When is it a good idea to refinance your mortgage? Should you take advantage of the historically low interest rates now available, or are there hazards to be leery of?
The general rule of thumb is that refinancing is worthwhile if you can reduce your interest rate by a full percentage point or more. But that's only a very rough guide - for some borrowers, a reduction of only half a percent may still produce significant savings, particularly if it's a large mortgage. And the interest rate is only one factor to consider when refinancing.
With that in mind, here's a few of the key points to consider when deciding whether to refinance your mortgage.
How much can you save?
For refinancing to be worthwhile, it has to save you more than you spend in fees to refinance. Since refinancing means replacing your current mortgage with a brand new one with better terms, you'll have to pay many of the same closing costs you did when you first bought your home - origination, appraisal, title search, etc.
Generally, it will cost about 2-3 percent of your loan balance to refinance, although this again is just a rough guide. The actual amount will vary from lender to lender, which is why it pays to shop around, and from state to state.
Use a mortgage calculator to figure out how much you'll save each month on the new mortgage versus the old one, then figure how many months it will take for your savings to exceed what you'll pay in closing fees. That's your break-even point. So if it's going to take 48 months to reach the break-even point, it's not worth refinancing unless you plan to own the house for at least that long.
Can you shorten your term? Lengthen it?
An important, but often neglected, aspect of refinancing a mortgage is the length of the new loan. If you've had your current 30-year mortgage for five years and refinance into another 30-year loan, you may cut your monthly payments but you're also extending your loan term another five years. This not only delays the time when you'll pay off your mortgage, but could actually cost you more in interest by stretching out the payments, even if you've reduced the interest rate.
A better choice is to choose a new mortgage with a term that matches the time remaining on your present loan. Fixed-rate mortgages are typically available in five-year increments, with 15, 20 and 30-year mortgages the most common. You can get a 25-year mortgage, but the rate may actually be a bit higher than you'd pay on a 30-year loan.
What you can do instead, is to refinance into a 30-year Fixed-rate mortgage, and ask your lender to set up your payment schedule so it will amortize in 25 years or however long you have left on your current mortgage. That way, you realize the benefits of a lower interest rate and still pay off the mortgage on the same schedule.
Another possibility is to refinance into a shorter term mortgage. Since 15- and 20-year fixed-rate mortgages have interest rates that are significantly lower than 30-year loans (currently about three-quarters of a percentage point difference between 30-year and 15-year loans), it can make sense to refinance into a shorter term, even if it raises your monthly mortgage payment. Again, an online mortgage calculator can help you figure exactly what your new payments would be.
When did you last refinance?
Mortgage rates have fallen to new historic lows several times in the past two years. This presents an often-overlooked hazard of refinancing too often. Some homeowners, in their quest for ever-lower interest rates, may fall into a trap of repeated refinancing, piling up closing costs so that they make no progress in actually paying down their mortgage - in fact, they're increasing their debt.
There's no hard and fast rule on this - if a new refinance will pay for itself during the time you plan to own the home, you will save money, regardless of how recently you previously refinanced. However, if it's going to take you more than seven or eight years to recover your closing costs, your savings may be so slight that you might be better off waiting to see if rates go even lower, or if they stay low long enough for you to pay down enough of your balance to refinance into a shorter-term loan.
Also, you need to be aware that some mortgages have penalties for prepayment, particularly if you pay them off within the first year or two. If that's the case with your mortgage, you want to be sure you're beyond that period before refinancing.
What's your credit score?
Even with mortgage rates at historic lows, you might not be able to take advantage of them if you've got blemished credit. Borrowers with FICO credit scores in 680-700 range will likely pay nearly half a percentage point more than those with "perfect" scores of 760 and above. Those with scores in the 620 range can expect to pay rates more than 1.5 percentage points higher.
The good news is that credit scores can improve significantly within a relatively short time, as long as you pay your bills on time and don't have a major blemish on your record, such as a bankruptcy or 90-day delinquency. For lesser blemishes, most of the impact on your credit goes away with two or three years, sometimes even less, so you might consider waiting for your score to recover.
What about a no-cost refinance?
A no-cost refinance is a bit misleading. You're still paying closing costs, they're just rolled into the new loan in the form of a higher interest rate. Generally, a no-cost refinance works to your advantage if you're not planning to stay in the home for a long time - say five or six years or so. If you end up living in the home another decade or more, it's going to cost you money because you're paying a higher interest rate than you would have if you just added the closing costs onto your loan balance.
This is where it pays to shop around. Obtain quotes from lenders for no-cost and conventional refinances and use an online mortgage calculator to see how the costs play out.
This are just some of the questions you'll need to ask yourself when considering a refinance, but they're fundamental ones. Answer them and you'll have a pretty good grasp on whether a refinance at this time makes sense for you.
Back during the real estate bubble of 2007 when people were using their homes like giant ATM machines, cash-out refinancing was an easy way to pull some equity out of a home to finance vacations, home repairs, cars and pay off credit cards.
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