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

The answer is, there's really no limit, at least under the law. Legally, you could close on one mortgage today, then go right out tomorrow and refinance it. The more relevant question is, how long *should* you wait before refinancing again? And how soon will your lender allow you to get out of your current mortgage?

As a practical matter, few lenders are likely to approve you for a new mortgage if you've been in your current one for less than a year. Your current lender may also have restrictions on how soon you can get out of the mortgage, usually in the form of prepayment penalties.

 

Look out for prepayment penalties

Some mortgages come attached with prepayment penalties if you refinance or otherwise pay the loan off in the first three to five years or so.  They don't actually prevent you from refinancing, but can make it more expensive and less attractive to do so.

Prepayment penalties can be steep, often equal to six month's interest charges on your current mortgage. These often phase out over time, so the bite isn't as bad if you refinance in the fifth year as it would be if you refinanced in the second.

These are often a feature of "no-cost" mortgages, where the lender charges a higher rate in exchange for waiving the closing costs. The lender wants to be sure the borrower stays in the loan long enough for the higher rate to make up the difference, so the prepayment penalty is their protection.

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.

 

3 major concerns - interest, costs and time

Aside from that, the only real limit on how soon you can refinance is whether you can save money by doing so. That's mainly a function of three things: 1) your mortgage rate, 2) closing costs and 3) how long you expect to live in the home.

The general rule of thumb is that you don't refinance unless you can save at least a full percentage point off your current mortgage rate. But the real question is how long it will take for your savings from refinancing to exceed your closing costs.

Suppose you owe $250,000 on a mortgage at 4.5 percent. Let's say that refinancing at 4.0 percent with $5,000 in closing costs will save you about $50 a month. So it will take you 100 months, or over eight years, to recover your closing costs (reach the break-even point). That's probably not a good deal unless you're planning to stay in the home a lot longer than eight years.

On the other hand, suppose you can refinance at 3.5 percent instead and save $110 a month (a 1 percent reduction saves you more than twice as much as a 0.5 percent reduction because of the way amortization works). So in that case, you'd break even in 45 months, or less than four years – a much more attractive proposition!

Calculating how long it will take to reach your break-even point is one of the key factors in deciding whether refinancing would be worthwhile.  If you can recover your costs in a reasonable length of time, refinancing would likely be worthwhile.

 

Refinancing again before your break-even point

A common misconception is that you shouldn't refinance again until you've reached the break-even point on your last loan. While this seems to have a certain logic to it, it doesn't work that way.

The cost of your last refinance is already baked into your current loan, either in the money you paid up front, by rolling it into your loan principle or in the form of a higher interest rate in a no-cost refinance. But if you can save money by refinancing, you'll save money. Your new savings will be on top of whatever you saved in the last refinance. Your concern should be whether you'll save enough from this refinance to make it worthwhile.

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 they aren't saving enough to make refinancing worthwhile. They get incremental reductions in their interest rate but keep spending more and more on closing costs, often losing track of what they've paid to get those "savings."

 

Can you refinance too often?

Some people do 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.

Borrowers may fall into this if they also extend their loan term at the same time, for example, refinancing into a  new 30-year loan when they have 25 years left on their current one. Their monthly payment drops, but because they're paying the loan off over a longer time, their total interest costs increase. And if they're repeatedly rolling their closing costs into the loan balance, their loan principle gradually increases as well.

 

What about "no-cost" refinances?

Many people are attracted to so-called "no-cost" or "zero-cost" refinances, where there is supposedly no charge to refinance. In reality, the closing costs are simply rolled into the new loan in the form of a higher interest rate.

These aren't a bad deal if you're only planning to own the home for a short time, but if you're planning to remain there longer than 5-8 years, you're usually better off rolling the fees into your loan balance and taking a lower interest rate. In addition, no-cost mortgages almost always include prepayment penalties to ensure that you keep the mortgage long enough for the lender to recoup the closing costs.

If you're looking to shorten your mortgage term - for example, going from a 30-year mortgage to a 15- or 20-year one (which offer much lower rates right now), you want to look at whether you can comfortably afford the accelerated payments and what your interest savings would be over the life of the loan or the period you expect to own the property, whichever is shorter.

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Published on October 1, 2011