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.
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