Refinancing depends on a number of factors, including how long you plan to live in your home, how much interest you expect to pay, and how soon you will be able to recover your closing costs.
Sometimes, it makes good financial sense to refinance your mortgage; other times, it doesn’t. For this to be worthwhile, the new interest rate has to be low enough to save you money even after taking the new loan closing costs into account.
Since you already own the property, refinancing would be more straightforward than obtaining a loan as a first-time buyer. Likewise, if you’ve owned your house or property for a long time and built up equity, you’ll have an easier time refinancing.
If you are refinancing for the purpose of tapping equity or consolidating debt, keep in mind that it may increase the number of years you will owe on your mortgage, which is not the wisest move financially.
When is Refinance A Good Idea?
So when is a refinance a good idea? It might make sense to refinance your mortgage if you can reduce your interest rate by 1% or more because of the money you’ll save. Your equity will also grow faster when you refinance to a lower interest rate. A refinance may be possible if rates are low enough to shorten the loan term. For example, from a 30-year fixed-rate mortgage to a 15-year one without much change to the monthly payment.
Falling interest rates might also influence your decision to switch from a fixed- to an adjustable-rate mortgage since periodic adjustments on an ARM could result in lower rates and lower monthly payments. This strategy is less viable in a rising mortgage rate environment. Due to the periodic ARM rate adjustments, you might be better off converting to a fixed-rate loan.
The best way to see if refinancing will actually save you money is to run the numbers using an online refinance calculator. You can find user-friendly tools online at SmartAsset and Realtor.com that will tell you immediately if a new loan will both lower your payments and save you money overall.
Other Considerations For Refinancing A Mortgage
1. Closing Costs
Closing costs are associated with refinancing. In addition to title insurance, attorney’s fees, an appraisal, taxes, and transfer fees, you’ll need to budget for other costs. Refinancing costs can range from 3% to 6% of a loan’s principal, which is almost as much as the initial mortgage and takes years to recoup.
You should be wary of “no-closing-cost” refinancings from lenders if you are trying to reduce your monthly payments. While the bank may not charge any closing costs, it will probably give you a higher interest rate in order to recoup those costs.
2. How Long You Plan to Stay in Your Home
You will want to calculate how much you will save every month when you refinance. Consider, for example, that you have a $200,000 mortgage loan. You assumed the loan with a 6.5% interest rate and a $1,257 monthly payment when you first took it out. Using a fixed interest rate of 5.5%, you could save $127 per month or $1,524 per year.
Should you decide to proceed with the refinance, your lender can estimate your closing costs. When your costs are approximately $2,300, you can divide that figure by your savings to determine your break-even point; in this case, the home should be refinance-able after 1.5 years in the home [$2,300 ÷ $1,524 = 1.5]. Generally, refinancing only makes sense after two years in the home.
The picture changes if you want to refinance with a reduction of less than 1%, say 0.5%. Using the same example, your monthly payment would fall to $1,194, saving $63 per month, or $756 annually [$2,300 * $756 = 3.0], so you would have to stay in the house for three years. The period would increase to nearly five-and-a-half years if your closing costs were higher, say $4,000.
3. Private Mortgage Insurance (PMI)
It is common for homes to be appraised for much less during periods of declining home values. In this scenario, the lower home valuation you have may mean that you don’t have enough equity to satisfy a 20% down payment on a new mortgage.
Refinancing may require a larger down payment than you anticipated, or you may have to carry private mortgage insurance, which will increase your monthly payment. You may not be able to save much even if interest rates drop.
On the other hand, a refinance that will remove your PMI will save you money, so it might be worthwhile just for that reason. When you have 20% equity in your home, you will not have to pay PMI. However, the case is different if you have an FHA mortgage loan or if you are considered a high-risk borrower.
Those who pay PMI, have at least 20% equity, and their lender will not remove the PMI should consider refinancing.
The Right Way to Refinance
If you’re going to refinance your mortgage, it pays to do it the right way. On the plus side, refinancing will reduce your interest rate and potentially save you a ton of money in interest. It may also lower your monthly payment, freeing up some room in your budget.
But if you don’t refinance the right way, it could take a toll on your overall financial picture and your net worth. Here are some dos and don’ts to help you avoid the potential pitfalls of refinancing.
- Don’t add more time to your mortgage, or it will erase the lifetime interest savings. Instead, refinance only for the amount of time you still have left on the original loan rather than restarting that clock.
- Do get a written estimate of the closing costs from the lender rather than using your best guess. This helps you save up for the closing costs rather than just rolling them into the loan, which means you’ll end up paying decades’ worth of interest on them or sticking them on a high-interest credit card.
- Don’t take cash out, no matter how tempting that sounds. Remember, lenders want you to borrow more money and they may try to talk you into a cash-out refinance, but that will just increase your debt and the interest you’ll pay.
- Do shop around for the best loan terms and lowest closing costs, just like you did with the original mortgage.
- Do plan to stay in the house for at least two years, or refinancing costs will almost always outweigh the benefits, no matter how low the new rate is.