How Soon Can Your Refinance Your Current Mortgage?

Friday, Dec 4, 2009

How soon can you refinance your mortgage after taking out your existing loan? With interest rates scraping along at historic lows right now, it’s a question many homeowners who bought or refinanced in the last couple years are asking themselves.

The good news is, there is no limit. Legally, you could close on one mortgage today, then go right out tomorrow and refinance it – although it’s hard to imagine a scenario where that would make sense. But if you’ve had your current mortgage for one or two years, you’re perfectly within your legal rights to refinance, regardless of whether your current mortgage is a refinance or the original one you purchased the home with.
 
That said, few lenders are likely to approve you for a new mortgage if you’ve been in your current one for less than a year. In addition, your current lender may have restrictions on how soon you can get out of the loan, usually in the form of prepayment penalties (because you’re using the new mortgage to pay off the old one). Typically, you need to stay in your current loan at least 12 months before refinancing without penalty, although not always.
 

Beware prepayment penalties

 
On the other hand, some mortgages come attached with prepayment penalties that apply for five years or more. This often phase out over time, so the bite isn’t as bad if you refinance in the fifth as it would be if you refinanced in the second.
 
Mortgage prepayment penalties come in a variety of forms, often 2-3 percent of the loan balance, or the equivalent of six month’s interest charges. They don’t actually prevent you from refinancing, but can make it more expensive and less worthwhile. But depending on how much you can trim your interest rate by refinancing, it can still turn out to be worthwhile.
 
Another thing to keep in mind – many homeowners may not be aware that they have a prepayment penalty on their existing mortgage, so it’s important to check before proceeding with a refinance. You don’t want to get stuck with an unpleasant surprise. Lenders are supposed to disclose prepayment penalties before you take out the loan, but some may gloss it over or it may simply not have registered with the borrower among all the other details of closing the mortgage.
 

Don't worry about the old break-even point

 
One of the major misconceptions people have with repeated refinancing has to do with the break-even point. The break-even point refers to how long it will take the savings from refinancing to equal the closing costs on the new loan – typically about four to seven years. The rule is, if you’re not going to be in the home long enough to reach the break-even point, it’s not worth it to refinance.
 
However, many people mistakenly apply this same rule to repeated refinancing – they assume they should not refinance until after they reach the break-even point or they’ll lose money. But that’s not the case. The cost of the last refinance is already rolled into your existing loan, either in the loan principal itself or in terms of a higher interest rate. But if you can save money by refinancing, you’re saving money. The only break-even point you need to be concerned about is the one on the new mortgage – if you’re still in the home past that date, you’ll come out ahead.
 
People do sometimes get into trouble by repeatedly refinancing their mortgage in a quest for the lowest possible rate. The problem here isn’t that they’re refinancing too soon, but that their savings on the new mortgage(s) aren’t enough to make refinancing worthwhile. They get incremental reductions in their interest rate but the principal keeps going up, up, up from the repeated closing costs, pushing their break-even date far into the future.
 

Declining equity may be a problem

 
Another concern, particularly in the current housing market, is that people who refinance soon after taking out their previous mortgage haven’t had much time to build up equity in their home. In fact, the way housing values have fallen, anyone who bought a home in the last 4-5 years will likely have less equity now than when they first purchased their home.
 
This can make it more difficult or expensive to refinance, particularly for homeowners who are “underwater” on their mortgages, owing more than the property is currently worth. But even reduced equity can be costly. If your equity in your home has declined to less than 20 percent of its current value, you’ll probably have to pay private mortgage insurance (PMI) on the new mortgage, even if you weren’t paying it before (because you’re above an 80 percent loan –to-value). That can effectively add another half-percent to your interest rate.
 
Furthermore, if you have very little equity remaining in your home, you’ll also find yourself paying a higher interest rate than someone who can meet the 80 percent loan-to-value standard. Interest rates typically go up a notch each time the loan-to-value ratio exceeds 80, 90, 95 and 97 percent, meaning you may not be able to get the rate you were hoping for if your house has significantly declined in value.
 
The easiest way to determine if refinancing at this point is to use a mortgage calculator, such as the ones at right. Check with a mortgage broker or shop around several lenders to find out what kind of rate you can qualify for, then plug the numbers in and see how much you’ll save and how long it will take you to recover your closing costs.
 
Remember too, to keep the term of your mortgage the same – if you’ve had your current 30-year mortgage for three years, assume 27 years for the new mortgage – assuming it as 30 years will exaggerate the savings. You may still end up refinancing into a 30-year loan, but you can use the results to figure out how much you should pay each month to pay it off in 27 years and stay on the same payoff schedule you’re on now.
 

No-cost refinance can simplify things

 
Finally, a popular option for many borrowers when refinancing is a so-called “no-cost refinance.” This is a bit of a misnomer, because the costs are actually covered by paying a higher interest rate than you would if you simply rolled the closing costs into the loan principal – about a quarter percent more.
This makes it easy to determine if you’re saving money by refinancing – if the “no cost” interest rate is lower than your current interest rate, you‘re coming out ahead. However, such loans typically come with prepayment penalties stretching out a number of years, since the lender needs that time to recoup the closing costs reflected by the higher rate. In addition, if you plan on staying in the home more than seven years or so without refinancing again, you’ll end up paying more than you would have if you’d taken the lower rate and simply rolled the closing costs into the principal.

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