When Should I Refinance My Mortgage Loan?

mortgage keysRefinancing your mortgage can be a money-saving move, but not in every situation. Since there are costs associated with all refinances, sometimes getting a lower interest rate can actually be more expensive than keeping your current loan. Plus, sifting through all those lender offers can be overwhelming and even misleading.

So how do you determine if a refinance is right for you? First, you need to understand how refinancing works. Then, consider your financial situation and what you want to accomplish with a refinance. Finally, take a look at loans you’re eligible for in the context of your long-term financial goals.

The factors below detail this process and will help you make an informed decision when it comes to whether or not to refinance your current mortgage.

Mortgage Refinancing 101

How Refinancing Works

When you refinance a mortgage on your home, you pay off the original mortgage and replace it with a new one. The terms and interest rate on the new loan may be different, but the property securing the loan is still the same.

Because you already own the property, it’s often easier to refinance than it was to obtain the original loan. Plus, if you’ve owned your property for a long time, you may have significant equity, which can also make refinancing easier.

Refinancing Costs

When it comes to cost, there are two important things to understand. The first is that refinancing comes with nearly as many costs as the initial mortgage. You’ll need to pay closing costs, title insurance, and attorney’s fees, and you may also have to pay for an appraisal, taxes, and transfer fees.

It definitely isn’t free. Though many banks advertise “no-cost” mortgages, there is really no such thing. However, you can get a no out-of-pocket cost mortgage where closing costs are either added to the loan balance (which means you’ll pay interest on the closing costs) or you’ll simply pay a higher rate to cover them.

Therefore, when considering a refinance, it’s vital to determine whether or not the savings you’ll get from a lower interest rate will offset the costs you’ll incur.

The second thing to understand is that closing costs vary according to your rate. In other words, if you want the lowest available rate, your closing costs will be relatively high. Alternatively, if you accept a slightly higher rate, your closing costs will likely be reduced.

For example, a refinance at 6% may cost you $2,000 to close, while a lower rate at 5.75% might cost you $3,000. But if you accept a rate of 6.5%, you might have no out-of-pocket costs at all. In fact, the 6.5% loan may have been advertised as a “no-cost” loan. You can see, however, that you are indeed “paying” for the closing costs in the form of a higher interest rate.

How Refinancing Can Save You Money

You’re probably already aware that a refinance can lower your monthly payment. However, a lower interest rate can also allow you to more quickly build up equity and pay off your loan balance. When you pay your mortgage each month, look at your statement carefully. Because your mortgage is amortized over a long period of time, typically 30 years, interest payments make up a significant chunk of the monthly payment, particularly during the first ten years of your loan.

house interest rateWhen you refinance your mortgage to a lower interest rate, the amount you pay in interest will go down. Moreover, if the term of your new mortgage matches how many years remained on your original mortgage, the amount you pay toward principal will go up. If you can afford it and don’t have other high interest debt, a good strategy is to direct the amount of money you save from a refinance toward extra principal payments. In this way, your monthly mortgage amount doesn’t change, but you can pay off your home much faster.

In most cases, a refinance that involves removing private mortgage insurance (PMI) will also help save you money. If your house has more than 20% equity, you will not need to pay PMI, unless you have a FHA mortgage loan or are considered a high-risk borrower. If you pay PMI and your current lender won’t remove it even though your house has at least 20% equity, you may want to consider a refinance for this reason alone.

Factors to Consider Before Refinancing

Consider the following to get a sense of how likely a refinance is to help you, if you’re eligible for one, and how to go about structuring it:

1. Current Interest Rate
Simply put, if you can get into a lower rate mortgage, a refinance is worth looking into. That said, consider how long it will take you to recoup closing costs.

For example, if you paid $2,000 to refinance your mortgage to a lower rate and your payment dropped by $150 per month, it will probably take you just over a year to break even. Generally, at least a half point to a full point reduction in the interest rate will save you enough money to cancel out the closing costs within a few years.

2. Jumbo Loan
If your initial mortgage was a “jumbo loan,” but you have since paid down the balance to less than $417,000, you may be able to get a “regular” refinance. In other words, there’s a good chance you’ll qualify for a lower interest rate even if rates in general have not gone down significantly.

3. Closing Costs
Since every mortgage, including a refinance, has fees associated with it, you need to understand how you’ll be paying them and if even it makes sense for your situation.

For example, in a “no cost” mortgage, you are either tacking the fees onto the loan balance or accepting a higher interest rate to cover those fees. If you can afford it, you’ll save money over the long-term by paying the fees out-of-pocket. However, if you can’t afford it and plan to stay in your house for a while, adding the fees to your loan balance is likely to work out better than accepting a higher interest rate. But if you expect to move over the next few years, accepting the higher interest rate will be more advantageous.

Consider your whole financial picture when determining whether or not to finance your closing costs. For example, if you have high interest credit card debt, but have cash on hand to afford the closing costs, it might make sense to pay off the high interest debt and finance the closing costs instead. Then, you can direct the payments that would’ve gone to your credit card to your home loan. In this way, you could pay off the closing costs faster than you could have paid off the same amount of credit card debt.

4. Mortgage Prepayment Penalty
Some mortgage brokers and banks offer loans that have a mortgage prepayment penalty. While a loan with a prepayment penalty usually has lower fees or a better rate, if you pay the loan off early, you’ll owe a fee which can be steep. The penalty is in place for a set period of time and can sometimes go down with time. But if you want to refinance your mortgage before the prepayment penalty expires, you’ll have to pay the penalty, which can ultimately make refinancing more expensive than it’s worth.

5. Length of Time You Stay in the Home
This is important in the context of closing costs and especially if you’ll consider a new loan with a prepayment penalty. When it comes to closing costs, you want to make sure you recoup the expense before you move.

For example, if you paid $2,000 in closing costs and you now pay $100 less in interest each month, it will take 20 months before you actually break even and start seeing real savings. If you financed those closing costs by adding them onto the loan balance, it will take even longer.

If you aren’t planning to be in your home for at least two years, it’s probably not worth refinancing at all – unless, perhaps, you refinance from a very high rate to a much lower one, or if you trade out-of-pocket closing costs for a higher interest rate that is still lower than your original mortgage rate.

If you’re entertaining the idea of tacking a prepayment penalty onto your new loan to get a lower rate, you should be committed to staying in your home through the prepayment penalty period, which could be as long as five years or more.

6. Your Credit Score
If your credit has improved since you got your original mortgage, you may now qualify for a lower rate. Check your credit report before you begin the process to confirm whether or not this is the case. Often, a few years of timely mortgage payments will improve your score such that you qualify for a lower interest rate.

Also, compare your debt and income now to what it was when you took out the original mortgage as banks generally require that your debt to income ratio fall below 36%. If you’ve since accumulated significant debt or if your income has declined, you may not qualify for a lower rate or a refinance at all in spite of stellar credit.

7. Amount of Equity in Your Home
Most lenders want to see some amount of equity in order to qualify you for a loan. Generally speaking, the more equity in your home, the easier it will be to refinance. A minimum of 20% is ideal, but you may still be eligible for a refinance even if you have less, such as 10%. However, the terms may not be as favorable.

To refinance with low or no equity, see the “Special Situations” section below.

8. Adjustable-Rate or Balloon Mortgage
Most people who have an adjustable-rate mortgage or a balloon payment mortgage count on refinancing at some point if they plan to stay in their home. Since refinancing can take a while, give yourself enough time to apply and get approved before your rate adjusts or your balloon payment comes due. Double-check your loan documents to make sure you know exactly when this date is and plan ahead.

9. Loan Term
Many people refinance into a new 30-year mortgage over and over, and never get closer to the goal of owning their home outright. Since interest makes up the large majority of your payments in the first ten to fifteen years, you will pay a lot more in interest if you keep resetting the clock.

Therefore, it’s generally a good idea to request a loan term as long as the number of years remaining on your original mortgage, as long as you can afford it. This allows you to pay off your mortgage according to the original schedule, while still reducing your rate. You can even refinance into a shorter term, which may raise your payment, but could get you an even better rate and set you up to pay the loan off sooner.

Remember, don’t focus on the monthly payment to the exclusion of the loan’s term, your rate, and closing costs. For example, some unscrupulous mortgage broker may show you a loan with a lower payment that actually has a 30-year term, high expenses, and a rate that isn’t much lower than the rate on your current mortgage.

10. People Listed on the Refinanced Mortgage
Generally, if you’re trying to add or remove someone from a mortgage, such as after a marriage or divorce, the lender will require you to refinance. This is done to determine whether or not the other person will qualify, or if you will qualify alone.

However, you may be able to work something out with the mortgage lender in order to accomplish your goal without going through a full refinance. This is especially true if the person who will have been on both mortgages can qualify for the mortgage by themselves.

11. Second Mortgage or Home Equity Loan
If you have a second mortgage, a home equity loan, or a home equity line of credit (HELOC), you may be able to save a lot of money by refinancing that into your primary mortgage.

To determine if you can, add up all your home loans together. If your home’s current value exceeds the value of the loans, you may be able to refinance your loans into one. In this way, you’ll pay one low rate on the entire amount instead of one low rate on your primary mortgage and a higher one on the second.

mortgage contract

Special Situations Regarding Home Equity

Either an abundance or a lack of equity can cause problems when it comes to refinancing. The following provides tips on how to best handle both situations:

Low or No-Equity Financing Options

As stated earlier, if you have low or no equity, refinancing can be difficult or downright impossible. However, for certain types of loans and specific situations, special refinancing options are available.

For example, if you have at least 5% equity in your home, you may qualify for a FHA refinance. Or for homeowners who have not missed any payments, the Home Affordable Refinance Program, or HARP, may help you refinance to a lower rate even if you’re upside down in your mortgage. This program allows homeowners with Fannie Mae or Freddie Mac mortgages to refinance up to 125% of their home’s current value.

Alternatively, if you are in imminent danger of losing your home, the Home Affordable Modification Program, or HAMP, can alter your loan contract via refinance, an extended loan term, and, if necessary, principal reduction to reduce your payments to no more than 31% of your gross income. Assistance is also available if you’re struggling to make payments on a second mortgage, if you’re unemployed, or if you’re already facing foreclosure. Most of these loans are provided by the government’s Making Home Affordable program, but are administered through regular lenders.

An option some homeowners have used in the past is a “piggyback” loan, where a home equity loan is taken out for 10% of the balance and a primary mortgage for the rest. Such an arrangement can mean more favorable terms. However, with the advent of more stringent lending requirements, it can be difficult to find a bank or credit union that is willing to do this type of loan.

Cash-Out Refinances

You may have seen advertising for refinances that say, “put money in your pocket” or “get cash from your home.” These are referred to as cash-out refinances. Here the new loan is larger than the old loan, and you get the difference in cash. But that cash isn’t free – it’s a loan off the equity in your home. In other words, you have to pay it back.

Though banks and brokers may tout this as a great way to pay off debt, take a vacation, or get college money, the problem is that it’s only a temporary fix. In fact, you could end up paying a lot more for that “cash-out” if you don’t have a plan in place for how you’re going to pay it back.

For example, when it comes time to sell your home, you won’t get as much from the sale because you’ll have a larger loan balance to pay off. Or, worse yet, if the real estate market declines, you could become upside-down in your mortgage and actually owe the bank money when you sell.

Cash-out refinances generally come with higher interest rates as well, even if you only take out a “small” amount of cash. Specifically, many banks offer refinancing to pay off your credit cards. But this is a risky move in which you trade unsecured debt (the credit cards) for secured debt (the mortgage). If you’re unable to pay your credit card debt, the worst that can happen is a court judgement to garnish your wages. But if you’re unable to pay the mortgage, you will lose your home.

Make sure you can actually afford a mortgage payment that incorporates your credit card debt before you secure that debt with your home. In fact, if you are having problems paying off debt, contact a credit counselor before you refinance your mortgage.

How to Save Money on Closing Costs

Here are a few ways to minimize the closing costs associated with a refinance:

  • If you need an appraisal and your home has significantly risen in value or there are many comparable sales in your neighborhood, ask your real estate agent if you can use an automated appraisal instead of a full appraisal. This will save a few hundred dollars.
  • Though you will still need title insurance, ask if you can get the “reissue” rate instead of the full rate.
  • See if your current lender can offer you a lower-interest refinance before you sign docs with a new lender. They may be able to get you a reasonable deal without as many costs.

Calculate Your Savings

Use a refinance calculator to figure out how much you can save. Sit down with your mortgage statement and determine how much you pay toward real estate taxes and homeowners insurance as these amounts won’t change when you refinance. However, if your property has gone down in value, you may be able to get your property tax lowered too.

Next, get a ballpark figure on closing costs from the bank or broker that handled your first mortgage. Average closing costs for a $200,000 refinance are $3,741, but amounts vary greatly by region. You will also need to know how long you have left on your loan and decide if you are going to keep the same loan term, or if you are going to shorten or lengthen it.

For example, say that Jim has been in his home and current mortgage for seven years. He initially paid $145,000 for the house and has a monthly mortgage payment of $916 at 6.5%. Even after seven years, he’s only paying off $206 of his principal per month, while $710 of his payment is going to interest. He still owes $130,897 on his mortgage.

He decides to refinance and is able to get a rate of 5% and pays $2,000 in closing costs. He opts to keep the same loan term and his new payment is $799 per month.

Old Mortgage at 6.5%

  • Monthly payment: $916
  • Interest amount: $710
  • Principal amount: $206

New Mortgage at 5%

  • Monthly payment: $799
  • Interest amount: $545
  • Principal amount: $254

Not only will Jim save $117 on his payment each month, but since he will pay less interest, he will pay down more of his loan balance than he was previously. However, when Jim does his taxes, he won’t have as much home mortgage interest to claim, and will lose some benefit there. But depending on Jim’s income tax bracket, that lost tax deduction may more or less wash with the accelerated pace at which he pays off principal. In other words, it will take Jim roughly 17 months to break even, whereby he recoups his $2,000 in closing costs.

In any case, run the numbers regarding when you’ll break even based on how much you’ll save monthly, how much equity you’ll build, and how much of a tax deduction you’ll give up with the lower interest rate. Only then can you determine when you’re likely to break even for your particular situation.

Final Word

Since applying for a refinance will hurt your credit score, determine whether or not you’re likely to qualify before you submit your application. If it seems unlikely, you may want to wait until your home’s value increases, your credit score improves, or your debt to income ratio declines. Also, plan ahead if you wish to apply for another loan, such as a car loan, that will affect your ability to refinance.

Then, once you’ve determined that you’ll qualify, review your financial situation, including your mortgage statement, and what you want to accomplish with a refinance. Be crystal clear on these points when you’re discussing options with a mortgage broker or bank and remember not to focus exclusively on any one thing, such as rate or payment, since you could end up missing an important component of the loan you agree to.

Most importantly, rely on your own assessment of your current mortgage relative to the new quotes you receive, and run numbers on each of them to determine which makes the most sense according to your goals.

Have you ever refinanced your mortgage? What were the main factors that led to your decision and how much did you end up saving?