(Updated Oct. 2014)
To refinance or not to refinance-that is the question. Even King Claudius may have been perplexed if he had to deal with refinancing the mortgage on his castle in Denmark. However, if you examine both the upside and the downside of the process, you should be able to find the appropriate answer, and know if refinancing mortgage is right for you.
Refinance to a lower rate
This is one of the most common reasons to refinance your mortgage and one of the best. If you're presently paying a 5.5 percent interest rate and have a chance to reduce it to 4.5 percent, that's a pretty good deal. Roughly speaking, that works out to a savings of about $120 a month on a $200,000 mortgage - or more than $1,400 a year.
Downsides: You'll have to pay a whole new round of closing costs. As a result, if you plan on being in your home for only a few more years, a mortgage refinance may not make sense, as it takes some time for your savings on interest to exceed what you paid in closing costs. (The same applies if you're scheduled to have the loan paid off in a few years.)
But if you expect to stay in the home another 5-7 years or more, it might be a wise move to scratch the mortgage itch and refinance to a new fixed-rate loan with a lower rate.
Another possible downside to refinancing is that you might stretch out your loan term again. So if you've got 22 years left on a 30-year mortgage and refinance into a new 30-year loan, you've just delayed paying off your loan by eight years. You might also find that stretching out the loan means you'll pay more in interest over the life of the mortgage despite having a lower rate.
Fortunately, lenders have a variety of mortgage products of varying durations, so you should be able to find one that comes close to matching the time you have remaining on your current loan.
Refinance to a shorter term
This is another very common reason for refinancing a mortgage - to pay it off faster. Many borrowers who initially take out a 30-year mortgage when they first buy their home eventually refinance it into a 20-year, 15-year or even a 10-year mortgage in order to hasten the day they own their home free and clear.
Refinancing to a shorter term not only allows you to pay off your mortgage more quickly - it'll probably enable you to get a lower rate as well. Interest rates on 15-year fixed-rate mortgages generally run well below that of comparable 30-year loans - usually about one-half to three-quarters of a percent lower - so the savings in interest over the life of the loan can be considerable.
Downsides: A shorter mortgage term means paying more toward your mortgage principal every month - which means higher monthly payments. If you bite off more than you can chew, payment-wise, you could find things get a bit tight, especially when you're hit by those unexpected expenses that inevitably crop up from time to time. The lower rate you can get with a shorter term can help blunt some of that increase, particularly if you're not shortening your remaining loan term too drastically, but you want to be careful not to get too aggressive when refinancing to a shorter term.
Move from ARM to fixed-rate
Mortgage rates are, to put it mildly, unpredictable. They've ranged as high as 18 percent on a conventional 30-year loan back in the early 1980s to as little as 3.3 percent for the same loan in late 2012. They may jump by half a percentage point in a single week or remain largely unchanged for months or even a few years at a time.
They also tend not to do what the experts predict, rising, falling or even simply standing still, contrary to all the speculation that went beforehand.
For this reason, a lot of people who started out with adjustable-rate mortgages (ARMs) choose to refinance them to a fixed-rate loan when the initial
period on an ARM ends and the loan is due to start resetting. A fixed-rate mortgage offers predictability and the assurance that your montly mortgage
payments will never increase during the life of the loan. With an ARM, there's a good chance your rate could rise significantly in the future and your
mortgage payments along with it.
Refinancing now also means you can lock in today's low rates for the life of your mortgage. Your monthly payment will be set for the long term, and you won't have any unpleasant surprises in your monthly mortgage bill. While rates have risen somewhat off their historic lows, they're still exceptionally low by historic standards and continue to be an outstanding bargain.
Furthermore, if you've got an ARM that came with a low "teaser" rate that is scheduled to sharply increase to a substantially higher rate in the not-too-distant future, refinancing to a fixed-rate loan or even a new ARM can save you a lot of money.
Downsides: As mentioned above, you'll have to pay for a new round of closing costs. So if you're not going to stay in the home more than a few years, or are on track to have the loan paid off before long, you might not save enough to recover your closing costs.
Another possible downside can occur in situations where mortgage rates are declining over time. In that case, your mortgage rate could actually fall when it comes time for your ARM to adjust. That happened to many borrowers who took out ARMs in the 1980s and 1990s - the rates they paid on their mortgages gradually fell over time, allowing them to continue paying lower rates than they could have gotten on a fixed-rate loan (note that these were on ARMs that tracked market rates fairly well and didn't have an initial "teaser" rate or steep increase built into the loan).
Of course, with mortgage rates as low as they are these days, there's not much room for them to move lower so it may be awhile before that scenario is seen again.
Deciding when to refinance your mortgage depends on your circumstances. Compare lenders, get quotes, know your rights, and select your advisors wisely. Then you can refinance with confidence, no matter how rotten things may be in the housing market where you live, or even in Denmark.