The decision to refinance your home depends on many factors, including the length of time you plan to live there, current interest rates, and how long it will take to recoup your closing costs. In some cases, refinancing is a wise decision. In others, it may not be worth it financially.
Because you already own the property, refinancing is likely to be easier than obtaining an initial loan as a first-time buyer. Additionally, if you have owned your property or house for a long time and have built up significant equity, that will make refinancing easier. But if tapping that equity or consolidating debt is your reason for a refi, keep in mind that doing so can increase the number of years that you will owe on your mortgage—not the smartest of financial moves.
Consider Closing Costs
The typical rule of thumb is that, if you can reduce your current interest rate by 1% or more, it might make sense to refinance because of the money you'll save. Refinancing to a lower interest rate also allows you to build equity in your home more quickly.
If interest rates have dropped low enough, it may be possible to refinance to shorten the loan term—say, from a 30-year to a 15-year fixed mortgage—without changing the monthly payment by much.
Similarly, falling interest rates could be a reason to convert from a fixed-rate to an adjustable-rate mortgage (ARM), as periodic adjustments on an ARM mean lower rates and smaller monthly payments. With rising mortgage rates, this strategy makes less financial sense. Indeed, the periodic ARM adjustments that increase the interest rate on your mortgage may make converting to a fixed-rate loan a wise choice.
However, there are costs involved in all of these scenarios. Your outlay will have to cover fees like title insurance, attorney’s fees, an appraisal, taxes, and transfer fees. These refinancing costs, which can be 3% to 6% of the loan's principal, are almost as high as the cost of an initial mortgage and can take years to recoup.
If you are trying to reduce your monthly payments, beware of "no closing cost" refinancing from lenders. Although there may be no closing costs, a bank will likely recoup those fees by giving you a higher interest rate, which will defeat your goal.
- It may be wise to refinance if you can lower your interest rate by 1% or more.
- Make sure you plan to stay in the home long enough to recoup the costs of refinancing.
- Getting rid of private mortgage insurance, or PMI, is one good reason to get a new mortgage.
Consider How Long You Plan to Stay in Your Home
In deciding whether or not to refinance, you'll want to calculate what your monthly savings will be when the refinance is complete.
Let's say, for example, that you have a 30-year mortgage loan for $200,000. When you first assumed the loan, your interest rate was fixed at 6.5% and your monthly payment was $1,257. If interest rates fall to 5.5% fixed, this could reduce your monthly payment to $1,130—a savings of $127 per month, or $1,524 annually.
Your lender can calculate your total closing costs for the refinance should you decide to proceed. If your costs amount to approximately $2,300, you can divide that figure by your savings to determine your break-even point—in this case, 1.5 years in the home ($2,300 divided by $1,524 = 1.5 years). If you plan to stay in the home for two years or longer, refinancing would make sense.
If the equity in your home is less than 20%, you could be required to pay PMI, which could reduce any savings you might get from a refi.
During periods when home values decline, many homes are appraised for much less than they have been appraised historically. If this is the case when you are considering refinancing, the amount at which your home is valued may mean that you lack sufficient equity to satisfy a 20% down payment on the new mortgage.
To refinance, you will be required to provide a larger cash deposit than expected, or you may have to carry private mortgage insurance (PMI), which will ultimately increase your monthly payment. It could mean that even with a drop in interest rates, your real savings may not amount to much.
Conversely, a refinance that will remove your PMI will save you money and may be worth doing for that reason alone. If your house has more than 20% equity, you will not need to pay PMI, unless you have an FHA mortgage loan or are considered a high-risk borrower. If you currently pay PMI, have at least 20% equity, and your current lender will not remove it, you should refinance.