How to Refinance Out of a Bad Mortgage

At any point in time, your mortgage is likely to represent your largest financial commitment. Because of the amount of money on the line, a bad mortgage can be financially devastating. A bad mortgage stretches the limits of your budget and may even lead to foreclosure and eviction. To refinance out of a bad mortgage, you must learn to anticipate interest rate trends. From there, you can perform a cost - benefit analysis where you compare up-front closing costs against long-term interest savings.

Mortgage Affordability

For affordability, your full monthly mortgage payment should be less than 30 percent of your monthly gross income. Your total debt payments, which include the mortgage, credit card bills, and car note, should also be less than 36 percent. With a bad mortgage, your payments are likely to far exceed these limits.

A bad mortgage is often a complicated product, which exposes you to payment shock when interest rates rise. Adjustable rate and interest-only mortgages feature variable rates that shift alongside the prevailing economy. When mortgage rates advance, you may be stuck with a payment that you cannot afford. Alternatively, a fixed-rate mortgage allows you to lock in a level interest rate throughout its term. An old fixed-rate mortgage would be a bad mortgage, if rates were to actually drop. For example, you may be five years into a 30-year fixed mortgage that charges an 8 percent rate. This would be a bad mortgage, if average rates on 30-year fixed mortgages were to have fallen to 4 percent.

Federal Reserve Board

The Federal Reserve Board manages the economy through its federal funds rate, which serves as a benchmark for all mortgage rates. Banks make overnight loans to each other at the federal funds rate in order to meet their Federal Reserve requirements. For mortgages, banks charge a premium above the federal funds rate to compensate themselves for taking on the increased risks of dealing with consumers, instead of other financial institutions. In recession, the Fed cuts its federal funds rate to encourage people to take out loans, spend money on big-ticket items, and invest money. At this point, you can best refinance a bad mortgage into a good fixed-rate mortgage and lock in a low interest rate. Be advised that the Fed will hike interest rates when commercial conditions recover -- to slow down the economy and guard against inflation.

Mortgage Refinancing Costs

Mortgage refinancing describes a series of transactions where you take out a new loan and use the cash proceeds to pay off your old, existing mortgage. When refinancing, you may owe both closing costs on the new home loan and pre-payment fees on the current mortgage. According to the Federal Reserve Board, you will pay 3 percent of your mortgage principal in closing costs. Closing costs help the bank protect its own financial interests, as they provide for a credit check, home appraisal, title insurance, and legal services. Alternatively, prepayment fees are in place to discourage you from paying off your old loan early through mortgage refinancing. For example, you may owe nine months worth of interest payments in pre-payment fees, if you pay off your mortgage within the first three years of its term.

Mortgage Calculator

You can pull up a mortgage calculator and toggle through interest rate and fee projections -- to determine whether a refinancing makes economic sense. As a good rule of thumb, you should refinance if you can lower a fixed mortgage rate by more than one percent and plan to own the home for at least the next ten years. When refinancing out of a bad interest only or adjustable-rate mortgage, you may be willing to accept any fees simply to avoid the stress of payment shock and potential foreclosure.

Mortgage Default and Loan Modification

You may need to negotiate a loan modification through the lender to save your home, if you are having trouble paying bills. A loan modification is a permanent reduction in your mortgage principal and interest rate that results in an affordable payment. Be advised that the lender is under no obligation to approve of any loan modification. The mortgage must also be in default, before loan modification talks can begin.

How to Refinance Out of a Bad Mortgage, Sources:

U.S. Department of Housing and Urban Development: Loan Modification FAQs

Federal Reserve Board: A Consumer's Guide to Mortgage Refinancing

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