While refinancing your home mortgage might sound like a good idea in theory, especially with interest rates falling, it may not always be possible for every homeowner or even desirable for that matter.
A refinance doesn’t always make sense financially. That’s particularly true for borrowers who plan to sell their home in the next few years, which makes it harder to have enough time to recoup refinance closing costs and fees.
Before taking the leap, therefore, homeowners should ask themselves the following key questions to help determine if a refinance makes financial sense.
Do I have enough equity in my home?
The amount of equity you have in your home is the difference between what your home is worth and what you still owe on the mortgage.
Homeowners need to have at least 20 percent equity in their home to qualify for a new loan without paying private mortgage insurance (PMI). Adding PMI to the cost of a new loan could negate the benefit of a refinance.
“Determining whether you have equity is always a key question to ask,” says Matt Hackett, senior mortgage and finance expert for Equity Now, a direct mortgage lender. “Home values have been rising for years and many homeowners have more equity than they may think.”
A cash-in refinance is yet another option to consider for those who may not have enough home equity. This involves the consumer bringing money to closing and paying down their mortgage so that there’s a lower balance owed, Hackett says.
Do I have good enough credit?
While borrower credit scores play a big role in securing a mortgage and a good rate, there’s a multitude of options for borrowers along the full credit spectrum, Hackett says.
Those with higher scores will qualify for lower rates, but there are Federal Housing Administration programs for borrowers with scores as low as 500.
What are my financial goals?
Identifying exactly why you want to refinance is a crucial part of the process, says Mounia Rdaouni, assistant vice president of mortgage specialized operations for Navy Federal Credit Union.
“Homeowners will refinance for different reasons,” Rdaouni says. “Examples include taking equity out of the house to pay for home improvements; securing a lower rate, term or payment and consolidating debt into one payment.”
Many homeowners, of course, refinance to lower their monthly payments and boost cash flow. If this is your inspiration, a mortgage calculator can provide an estimate of what the new monthly payment will be after refinancing.
Other homeowners, however, pursue refinancing to obtain a shorter-term loan (often with with higher monthly payments) so that they can reduce overall interest costs and own their homes outright faster. Swapping a 30-year mortgage for a 15-year loan, for example, is a way to accomplish that goal.
“As a homeowner, you should discuss the reasons why you’re refinancing with your lender so they can help you find the product that would best meet your needs,” Rdaouni says.
You may also want to consider whether you hope to retire without a mortgage before signing on for a new 30-year loan.
“Some are not aware, but they could be refinancing into a brand new 30-year, which means they are starting over on their terms and not where they left off,” says Michele Hammond, a private home lending adviser with Chase.
One additional consideration: Those who have employment concerns may want to refinance into a loan with the lowest possible monthly payment in case a job loss occurs.
How long do I plan to stay in this home?
A refinance generally costs about 2 percent to 3 percent of the loan amount. So, before spending that money, think about how long you plan to stay in the home and then determine whether you’ll reach the break-even point before moving. Your break-even is the point when the savings you are realizing outweighs the costs incurred.
A rule of thumb is to calculate how many months it will take to recoup your closing costs. Let’s say your closing costs are $3,000 and your monthly savings are $125 per month after the refinance. It would take you 24 months to break even and start enjoying the cost savings of the lower interest rate on the new mortgage.
“The length of time a homeowner plans to keep the mortgage is a key input in the cost benefit analysis,” Hackett says. “All else being equal, the shorter the time in the house, the less likely it makes sense to refinance.”
Additionally, if you’re close to paying off your mortgage it might not make sense to spend the money on a refinance. That money might be better off going toward paying off the principal on your current mortgage.
“It might be tempting in a low-rate environment to want to take advantage of the lowest rate available. However, homeowners need to be aware of the closing costs and time it will take them to break even,” says Rdaouni of Navy Federal Credit Union.
What are the terms of my current mortgage?
Borrowers with adjustable-rate mortgages or interest-only loans might want to consider the potential benefit of switching to a fixed-rate loan as part of a refinance. With a fixed-rate loan, you have the peace of mind of knowing that your monthly principal and interest payment won’t change over the life of the mortgage.
While new loans today rarely have a prepayment penalty, some homeowners still have loans with that restriction, which could reduce the financial gain of a refinance.
Hackett suggests downloading a current mortgage statement to identify the various terms of your current loan.
Do I have a second mortgage or line of credit?
Those who have a second mortgage will face additional complexity when refinancing.
“This will change the calculus of the refinance benefit calculation,” Hackett says. “Do you want to pay off and close the second mortgage or do you want to leave it open and resubordinate it to the new first mortgage? Both scenarios are possible in a lot of situations, but it is important to discuss this with your loan officer.”