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 built up significant equity, that will make refinancing easier. However, 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.
The Home Appraisal: Key To A Successful Refinance
- 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 (PMI) is one good reason to get a new mortgage.
Reasons to Refinance
So when does it make sense to refinance? The typical should-I-refinance-my-mortgage rule of thumb is that if you can reduce your current interest rate by 1% or more, it might make sense 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 should mean lower rates and smaller monthly payments. In a rising-mortgage-rate environment, 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.
Consider Closing Costs
There are closing costs involved in all of these scenarios. Your outlay will have to cover charges for title insurance, attorney’s fees, an appraisal, taxes, and transfer fees, among others. 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.
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 one-and-a-half years in the home ($2,300 ÷ $1,524 = 1.5). If you plan to stay in the home for two years or longer, refinancing would make sense.
If you want to refinance with less than a 1% reduction, say 0.5%, the picture changes. Using the same example, your monthly payment would be reduced to $1,194, a savings of $63 per month, or $756 annually. $2,300 ÷ $756 = 3.0, so you would have to stay in the home for three years. If your closing costs were higher, say $4,000, that period would jump to nearly five-and-a-half years.
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.
Consider Private Mortgage Insurance (PMI)
During periods when home values decline, many homes are appraised for much less than they had historically been appraised to be worth. If this is the case when you are considering refinancing, the lower valuation of your home may mean that you now 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 20% or more 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 the PMI, you should refinance.