When should you refinance your mortgage?
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There are many reasons to refinance a mortgage, from lowering your monthly payments to paying off your loan faster to tapping your home equity for cash. Of course, people usually think of refinancing when interest rates are sinking or stable — and the current environment has been anything but. Still, swapping your old home loan for a new one could make financial sense for you. Let’s look at why and when you should refinance your mortgage.
Should I refinance my mortgage?
Mortgage rates have been on a wild ride in 2022; after reaching record lows, they currently hover around 7 percent — higher than they’ve been for 20 years. Consequently, now is likely not the ideal time to refinance for many borrowers.
However, the math isn’t as simple as comparing the interest rate you locked in when you were approved for your mortgage versus the rate you can qualify for now. Take into account this trio of factors from Bill Packer, executive vice president and chief operating officer of mortgage lender American Financial Resources:
- The after-tax monthly savings (new payment compared to old payment, after any tax-favored treatment)
- The amount of time that you intend to be in the home
- The cost to obtain the new mortgage
Once you know these three things, you can then calculate your return and see if it is positive, Packer says.
In addition, there are fundamental questions about your financial goals and current liabilities you should consider.
Reasons to refinance your mortgage
Generally, if refinancing will save you money, it’s a good move to make. Helping you build home equity and pay off your mortgage faster are also strong reasons.
More specifically, refinancing makes sense if you can lower your interest rate by one-half to three-quarters of a percentage point, and if you plan to stay in your home long enough to recoup the closing costs that taking out the new mortgage incurs.
Lower your interest rate
If interest rates have dropped since you first obtained your mortgage, a rate-and-term refinance can provide you with a lower rate. It’s also possible that you’ll qualify for a better interest rate if your credit score has improved since taking out your current loan.
The best mortgage rates and terms go to those with the best credit, so check your credit report to have a solid understanding of your risk profile. If you’re carrying a lot of credit card debt or you’ve missed a payment recently, you might look like a riskier borrower.
Consolidate high-interest debt
You can use a cash-out refinance to tap your home’s equity and lower or pay off high-interest debt. Whether it’s credit card balances or other forms of debt that are costing you a fortune, using the funds from a cash-out refinance could save you several thousands of dollars.
Eliminate private mortgage insurance
If your home’s value has increased, you could refinance to get out of paying private mortgage insurance (PMI) on conventional loans or mortgage insurance premiums (MIP) on FHA loans. Most commercial home loan products require PMI until you have achieved 20 percent in equity. MIP on the standard modern FHA loans (post-2013) never gets canceled until you pay off the loan (with some exceptions depending on the size of your down payment).
You don’t plan to move soon
Refinancing could also be sensible if you qualify for more competitive loan terms and are planning to stay put for some time to take advantage of the cost-savings. However, it might not be smart to refinance if you plan to move in the near future, which gives you little time to recoup the costs associated with taking out a new loan.
Change your loan term
If you’re struggling to make your monthly mortgage payments, you can refinance to get a longer loan term, which means a smaller monthly payment. However, overall the loan will be more costly since you will be paying interest for a longer period.
Pay for home renovations
Home renovations can be costly and aren’t worth depleting your reserves for. But if they will increase your home’s value, pulling out funds through a cash-out refinance could be a worthwhile investment.
When not to refinance
So, when is it a bad idea to refinance? It might not be smart to refinance if you recently bought a home or plan to move in the near future, which gives you little time to recoup the administrative expenses of taking out a new loan. Or if you just want to splurge on some big-ticket items (even if it’s a new house).
How much can I save by refinancing?
The amount you can save by refinancing depends on several factors, including your closing costs, which typically total 2 percent to 5 percent of the principal amount of the loan. If you borrow $250,000 and closing costs are 4 percent, for example, you would owe $10,000 at closing.
Rather than require all that money upfront, many lenders let you roll the closing costs into your principal balance and finance them as part of the loan. Keep in mind, though, that adding those costs to the loan only increases the total amount that will accrue interest, ultimately costing you more.
You won’t begin to reap the benefits of a refinance until you reach the break-even point, where the amount that you save exceeds the amount you spent on upfront costs. To determine the break-even point on your refinance, divide the closing costs by the amount you’ll save each month with your new payment.
Let’s say that refinancing will save you $150 per month, and the closing costs on the new loan are $4,000.
So, if you were to close your new loan today, you’d officially break even just over two years and two months from now. If you live in the home for an additional five years after that point, the savings really start to add up — $9,000 total.
You can use Bankrate’s refinance break-even calculator to figure out how long it will take for the cost of a mortgage refinance to pay for itself. If you think you might sell the home before your break-even point, refinancing might not be worth it.
Example of a mortgage refinance
Let’s say you took out a 30-year mortgage for $320,000 at a fixed interest rate of 6.23 percent. Your monthly payment would be $1,966. Over the life of that loan, you’d pay approximately $707,901, which includes $387,901 in interest.
Now say about 15 years into the loan, you’ve paid $86,551 toward the principal and $257,499 in interest and you want to refinance the remaining $233,449 of your principal balance with a new 15-year fixed-rate loan at 5.11 percent.
The new loan would trim your monthly mortgage payment to $1,859 per month, giving you an additional $107 of wiggle room in your monthly budget. Over the life of the loan, you’d pay $334,756, of which $101,307 would be interest. Add in the $344,050 in principal and interest you paid on the previous mortgage, and your total cost will be $678,806.
By refinancing, you’d not only lower your monthly payments — you’d see a long-term savings of about $30,000, less closing costs, compared with your original loan.
How long does it take to refinance a mortgage?
Refinancing a mortgage doesn’t happen overnight. The same work involved in your first mortgage — verifying your income and reviewing your credit and debt, appraising the property, underwriting and closing — applies here, too. The average refinance took 52 days to close, or about a month-and-a-half, as of December 2022, according to ICE Mortgage Technology. That’s about one day longer than a new home purchase closing.
Some lenders complete closings faster thanks to automated online processes. When shopping around for refinance options, ask each lender about their average closing times and the estimated closing costs you’d need to pay.
Is refinancing worth it?
If it frees up money in your monthly budget or reduces the overall cost of the loan, refinancing is well worth the work and money.
There’s no one correct path to do it, however — there are a variety of ways to refinance your mortgage. You might want to switch from an adjustable-rate mortgage to a fixed-rate loan that has a steady monthly payment, or you might want to shorten the term of your loan from a 30-year to a 15-year and save yourself a bundle in interest charges. You could also simply move from one 30-year mortgage to another 30-year mortgage with a lower rate.
Additionally, refinancing presents a way to get rid of PMI after you have accumulated 20 percent equity in your home.
Many homeowners opt for a straight rate-and-term refinance that lowers their interest rate and gives them a comfortable repayment term. Some want a lower monthly payment to free up money for other expenses, such as college tuition or an auto loan.
While rate-and-term options should help you save money, a cash-out refinance can help you borrow more of it. With this approach, you’re able to take additional cash out with the new loan that can go toward other financial moves, such as paying off credit card debt (since that has a higher APR, you’ll be reducing the cost of the debt) or for a big home remodeling project.
There are pros and cons for cash-out refinances, so you’ll need to think carefully about what you plan to do with the money to figure out whether you should increase the size of your home loan. By taking on more debt, you’re ultimately making paying off your mortgage more challenging, and likely more expensive.