Should I refinance my mortgage? That's a question most homeowners ask themselves from time to time. While rates remain near historic lows, there are signs they may soon be moving higher, leaving borrowers to wonder if they should act now while the opportunity is there. As is often the case, the devil is in the details.

Every day, thousands of homeowners refinance their mortgages.  They do so for a variety of reasons, but they all come down to one underlying purpose – to save money. So the question comes down to whether you'll save enough to make refinancing worthwhile.

The basic rule is that you want to be able to reduce your mortgage rate by at least a full percentage point when refinancing. But that doesn't apply in all situations – a smaller reduction may still provide a benefit and in some types of refinancing there may be other considerations in addition to the rate.


Reasons for refinancing

People refinance their mortgage to save money, but there are several ways to do that. Some of the main ones are:

  • By refinancing to a lower mortgage rate
  • By shortening the mortgage term to pay the loan off faster
  • By converting an adjustable-rate mortgage to a fixed-rate loan
  • By combining a primary and second mortgage into a single loan
  • By getting rid of mortgage insurance on an FHA loan

Of course, you can do several of these in a single refinance. For example, mortgages with shorter terms have lower rates than longer loans do, so refinancing from a 30-year to a 15-year mortgage may not only help you pay your loan off faster, but reduce your mortgage rate as well.

Each of these options can save you money, but they do it in different ways. But in all of them, the question of whether to refinance or not comes down to how much you can save vs. how much it will cost you to refinance.

We'll look at each of them, starting with the most popular option, refinancing to reduce your mortgage rate.


Will your savings exceed refinance costs?

Refinancing costs money. You can expect to spend anywhere from 2-6 percent of the loan amount on closing costs, depending on where you live and whether you pay for discount points to reduce your rate even further.

Generally speaking, refinancing to a lower mortgage rate will save you money over the long run. The real question is how long it will take your monthly savings to exceed what it cost to refinance.  

For example, let's say you pay $7,500 in closing costs to refinance a $250,000 mortgage – that's 3 percent of the loan balance. Let's also assume that refinancing to a lower rate reduces your mortgage payments by $150 a month.  In that case, it would take you just over 4 years to recoup your closing costs – 50 months to be exact. Not a bad deal.

On the other hand, suppose you can only reduce your rate enough to save $50 a month. That would take you 150 months to recover your costs, or 12 ½ years. That's not such an attractive opportunity.

The time it takes for your savings to exceed your refinance costs is called the break-even point. Obviously, shorter is better. As a rule of thumb, you want to be able to break even within five years or less. That's about how often people tend to move, and if you relocate before you break even, you'll have lost money.

That isn't a hard and fast rule, though. If you expect to stay in the home a long time, you might find it worthwhile to refinance even it's going to take you 8-10 years to break even. It depends on if you think the accumulated savings over the entire loan will be worthwhile.

A refinance calculator can help you determine this – just follow the link for an example. This particular one is designed to help you find your break-even point and monthly savings. It even takes into account your income tax rate to determine the effect of the difference in the mortgage interest deduction between the two loans.


Shortening the term

Shortening the length of the loan, such as switching from a 30-year to a 15-year mortgage, is another major reason for refinancing. Paying your loan off faster can dramatically reduce your total interest costs.  Short-term mortgages also have lower rates than longer ones do, letting you save that way as well.

On the downside, paying off your mortgage faster generally means higher monthly payments. But because short-term refinance rates can be significantly lower than what you might currently be paying on a 30-year mortgage, you can often refinance to a shorter term with little or no increase in your monthly payments.

Since you're not likely to reduce your monthly payments by shortening your loan, you won't be looking at your savings in terms of a break-even point. Instead, you want to look at how much interest you can save over the remainder of your loan. And that can be substantial.

For example, suppose you still owe $200,000 on a 30-year mortgage at 5.5 percent that you've had for 10 years. Your monthly payment would be about $1,375. Refinancing into a 15-year mortgage at 3.5 percent would let you shave five years off your loan while increasing your payments by only $55 a month – to about $1,430.

You'd not only pay off your mortgage sooner but you'd be cutting your remaining interest payments by more than half! From $130,000 over 20 years to $57,000 over 15! That's a huge savings.  Of course, you actual savings would depend on how current refinance rates compare to the rate you have on your existing mortgage, and those vary over time.

The big question when refinancing to a shorter term is whether you can afford the increase in monthly payments. Even if you can save big over the long term, it won't help if your new payment schedule puts you in a bind. So consider different loan lengths – for example, perhaps a 20-year term instead of 15. Your lender may be willing to offer you other lengths as well.


Converting an ARM to a fixed-rate loan

Another common reason to refinance is to exchange an adjustable-rate mortgage (ARM) for a fixed-rate one. Here, the reason isn't immediate savings but predictability – with an ARM, you could be exposed to higher rates down the road that will increase your monthly payments. With a fixed-rate loan, your monthly payments are set for the duration.

This, more than any of the other situations, is a judgment call. What do you think rates are going to do over the next few years? If you think they're going to rise, then refinancing to a fixed-rate is your best bet. But if they fall, you'd save money if you stayed in the ARM and let your monthly home payments fall along with them.

Another question is whether you can handle a significant increase in your mortgage payments. If your budget would be stressed if your mortgage rate went up a percentage point or two, you might want to switch to a fixed-rate just to protect yourself and have a predictable budget. It all comes down to what you're comfortable with and what rates might do.


Combining a first and second mortgage

Another reason for refinancing is to roll a home equity loan, piggyback loan or other second mortgage into your primary mortgage, so you're just dealing with one loan. You do this through a cash-out refinance of your primary mortgage and use the proceeds to pay off the second loan.

Because second mortgages have higher interest rates than primary loans do, this can often allow you to reduce your interest payments. Primary mortgages can also be financed over longer terms than second mortgages will allow, up to 30 years, so this can let you stretch out your payments if you wish.

Just like with a rate-reduction refinance, you want to figure how long it will take you to reach your break-even point – how long it will take your interest savings from rolling your HELOC, home equity loan or piggyback mortgage into your primary mortgage to exceed your refinance costs. 

Because second mortgages tend to have relatively short terms – often 10 years – you'll want to recoup your refinance costs fairly quickly. If it's going to take nearly as long as the time left on your second mortgage, refinancing may not be worthwhile.


Getting rid of mortgage insurance on a FHA loan

This is a special situation created by a change in FHA policy a few years ago. With most mortgages, including FHA loans, you have to pay mortgage insurance if you put less than 20 percent down on your home purchase. This is billed as a monthly fee along with your regular mortgage payment.

Traditionally, you can cancel mortgage insurance on most loans once you reach 20 percent home equity. However, under the new FHA policy, mortgage insurance fees are a permanent fixture of any loan with less than 10 percent down.

The way out of this is to refinance once you reach 20 percent equity. But if rates have risen, it might not be worthwhile if your new mortgage rate is higher than your old one. Again, you want to figure your break-even point, comparing your monthly payments with the new rate to your current payments with the old rate plus FHA mortgage insurance.



Any of these can be good reasons for refinancing, though each has its own considerations to take into account.  But if you weigh the costs and benefits carefully, you should be able to make the right choice with confidence.

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