Figuring Out if You Should Refinance Your Mortgage
It's not a question with a simple answer. Whether or not refinancing makes sense for you will depend on the type of loan you have, the interest rate you're paying, your credit score, how much equity you have in the home and a variety of other factors. And some of these will determine whether you're even able to refinance in the first place.
The general rule of thumb is that you need to shave at least a full percentage point off the interest rate on a fixed-rate mortgage to make refinancing worthwhile, due to the additional closing costs of taking out a new mortgage. Since closing costs typically run at least 2 percent of the total loan amount, you need to be able to save at least that much in reduced payments to make it worthwhile.
Break-even point is key
To figure out if it's worthwhile to refinance a fixed-rate loan, you need to calculate the break-even point - how long it will take for what you save by reducing your monthly payments to equal what you paid in closing costs.
For example, consider a $250,000 30-year mortgage at 6 percent interest. The monthly payments, not including taxes and any insurance, would be about $1,500. The same mortgage at 5 percent interest would be $1,340 - a savings of about $160 a month. Assuming $5,000 in closing costs to refinance (2 percent of the loan), it would take 32 months - just over two and a half years - to make up the difference.
The actual calculation is a bit more complicated than that, however. You have to take into account how long you've been paying on your existing mortgage and how many years you'll be paying on the new loan. So if you've had the loan for 5 years, paying 6 percent interest, you'd have paid down the balance to about $232,000 in the example above.
So if you refinance $236,640 (including $4,640 in closing costs, 2 percent of the loan amount) at 5 percent over 25 years, your new monthly payment will be $1,383 - a savings of $117 a month. At that pace, it would take you 40 months - three years, four months - to reach your "break-even point," which is still a fairly short time in the overall scheme of home ownership. But you can see that you have to do more than just compare different rates on a 30-year loan - you have to figure out how a refinance would apply to your own situation.
Small changes can make big differences
Suppose your closing costs are 3 percent of the balance instead of 2 percent? In some states, closing costs are higher than in others. In that case, you'd have $6,960 in closing costs, and monthly payments of $1,397. Now you're only saving $103 a month, and with the higher closing costs to cover, you won't reach your break-even point for 68 months - more than five and a half years. So seemingly small changes in terms can make a big difference in whether a refinance is worthwhile.
Of course, if you're just looking to reduce your monthly expenses, perhaps due to a drop in income, you can always refinance back out to a full 30 years. You'll pay more in interest costs than you would if you refinanced over a shorter term, but you can significantly cut your monthly payments this way. In the example above, refinancing $236,640 over 30 years instead of 25 produces a monthly payment of $1,270 - $ a savings of $230 over the current loan. And if you've been paying down your mortgage for seven or 10 years, the monthly savings would be significantly greater.
Refinancing into a 15-year mortgage
Another option, particularly if you've been paying on your mortgage for 10 years or so, is to refinance into a shorter term. Right now, 15-year fixed rate mortgages are running about half a percent below 30-year rates, so refinancing to pay off your loan more quickly may be more affordable than you think. Let's do the numbers again. Assume you have a $250,000 mortgage you've been paying on for 10 years at a 7 percent rate (at the low end for rates 10 years ago).
After 10 years with monthly payments of $1,663, you'd still owe $214,530. Refinancing that into a 15-year mortgage at 4.5 percent (borrowing $218,820, assuming 2 percent closing costs) would produce a monthly payment of $1,674 - just $11 more than you're paying now, but enabling you to pay off your mortgage five years sooner! Of course, you could also refinance at the higher, 30-year rate over your remaining 20-year term, which would produce a monthly payment of $1,444, saving about $220 a month.
Credit score, home equity affect rates
Of course, not everyone can qualify for the lowest rates available today. To do so, you have to have excellent credit - many lenders are requiring credit scores of 720, 740 and even higher for their best rates. You're also going to have to have equity in your home, which many people lost when housing prices collapsed over the past three years. If you don't have at least a 20 percent equity in your home, compared to its current market value, you're not going to be able to get the lowest rates.
You can still refinance with lower credit scores or less equity in your home, but you'll be paying a higher rate. To know just what rate you can qualify for, you'll really need to check with a lender or broker. Run their numbers by them and see what kind of terms you can get. They can also help you work out the calculations such as those above to see how much you might be able to save by refinancing.
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