When is refinancing a mortgage worth it?

Young couple leaning against a white backdrop with a laptop while discussing whether they should refinance their mortgage Image: Young couple leaning against a white backdrop with a laptop while discussing whether they should refinance their mortgage

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Refinancing your mortgage means you replace your existing mortgage with a new one. Your new mortgage pays off your old one, and you’re then responsible for paying off your new mortgage. But when — if ever — is the right time to do this?

When does it make sense to refinance?

In general, if you can save money on your existing mortgage by refinancing, it could make sense to explore. Here are some situations when that might be the case.

Use our calculator to see if refinancing is worth it

Mortgage rates have gone down.

Mortgage rates can fluctuate, as they’re impacted by a variety of factors, including U.S. Federal Reserve monetary policy, market movements, inflation, the economy and global factors.

If mortgage rates fall, you may be able to save by securing a lower interest rate than you have on your existing loan, says Steven Fung, sales lead at online mortgage lender Clara Lending.

This is known as rate-and-term financing — when you refinance your mortgage for one with a lower interest rate, and one that usually has the same remaining term.

So how much should mortgage rates fall before you consider refinancing? The traditional rule of thumb says refinance if your rate is one to two percent below your current rate.

But in reality, each borrower’s financial goals and needs are different, Fung says. A one percent interest rate reduction may net significant savings on a $1 million mortgage but will be less beneficial for a $100,000 mortgage.

There are costs associated with refinancing that are important to weigh up if you’re thinking of refinancing (covered in more detail below).

Another time refinancing may be helpful is if you have a fixed-rate mortgage and anticipate interest rates will continue to fall. In this instance, you may want to explore converting to an adjustable-rate mortgage (ARM).

With an ARM, the interest rate changes over time, usually in relation to an index, and so your payments can go up or down.

Converting to an ARM may make most sense if you’re planning to move in a few years, Fung says, since you’re forgoing the stability of a fixed-rate loan. Be aware that if interest rates go up, your ARM will likely go up too.

One thing to note: The initial rate that you get with an ARM stays in effect for a limited period — this could range from one month to five years or more.

Your home has increased in value.

If the value of your home has gone up, you might also get some benefit from refinancing, especially if you have other high-interest debt to pay off.

When you get a cash-out refi, you take out a new mortgage that’s larger than what you previously owed, and you receive the difference in cash. A cash-out refinance is an alternative to a home equity loan.

For instance, say you took out a $160,000 mortgage five years ago for a $200,000 house (you already made a $40,000 down payment). After making regular mortgage payments, you now only owe $100,000 on the mortgage.

But because the property market has gone up, the value of your house has increased — it’s now worth $250,000. Because the house is more valuable, you may be able to refinance for more than the balance of your mortgage, which is $100,000.

If you end up refinancing, say, for $120,000, you can now take the $20,000 difference in cash and use it to pay down high-interest debt or for major purchases, home improvements and so on.

With cash-out refinancing, it’s important to make sure you’re using the money responsibly and not getting into unsustainable debt — remember that it’s part of a loan, so you’ll have to pay it back along with the rest of your mortgage.

You’ll also want to make sure you don’t end up paying more in mortgage interest than the interest you would pay on any debt you’re using the cash to pay off.

Your credit has improved.

Your credit score is a significant factor in determining your mortgage rate. Generally speaking, the higher your credit score is, the lower the interest rate you’ll receive.

Let’s look at a simple illustration. If you have a 30-year fixed-rate mortgage of $150,000 and your FICO credit score is within the 660-679 range, the myFICO Loan Savings Calculator estimates you could pay 4.522 percent APR (based on interest rates as of February 2, 2017).

With this interest rate, your monthly payment would be $762 and your total interest paid across the 30 years would amount to $124,316.

In comparison, if your credit score were in the 700 to 759 range, the calculator estimates your monthly payment would drop to $727. Over the life of the loan, you could save $12,417 in interest.

Check your credit now

Mortgage rates are going up and you currently have an adjustable-rate mortgage.

If mortgage rates are increasing and you currently have an ARM, you may want to consider refinancing and converting to a fixed-rate mortgage. That’s because with an ARM, your rate may increase beyond what you would pay with a fixed-rate mortgage. If you’re concerned over future interest rate hikes, a fixed-rate mortgage could provide some peace of mind.

Tips to figure out whether refinancing is right for you

Calculate your break-even point.

“Every refinance has a break-even point — a point in time where the costs associated with refinancing the loan are equal to the savings,” Fung says.

Figure out how long it may take for your refinance to pay for itself. To do this, divide your mortgage closing costs by the monthly savings your new mortgage will get you. If you’re paying $5,000 in closing costs but you’ll save $200 per month as a result of refinancing, it will take you 25 months to break even.

“In some cases, the numbers just don’t add up in your favor, and you’re better off sticking with your current loan,” Fung advises.

If you don’t plan on staying in your home past the break-even point, it probably doesn’t make sense to refinance.

Use a mortgage refinance calculator.

By entering your current interest rate, monthly payment and your new (or your best guess) loan terms, a calculator can show you how the costs of the two mortgages would compare.

Factor fees into the picture.

Refinancing a mortgage can be expensive. Here are some typical fees you may have to pay:

  • A mortgage application fee (which might range from $250 to $500).
  • Origination fee (about 1 percent of your loan value).
  • Appraisal fee ($300 to $600).

Make sure you know what costs to expect and whether you can afford them.

Consider the term of your new loan.

“Most people think that if the rate is lower, they should automatically refinance — but not so fast!” Fung says. “Remember, along with that lower payment comes another 30 years of paying off that loan, potentially increasing the overall amount of interest you’ll pay over the life of the loan.”

Before you decide to refinance, calculate your break-even point and how the overall costs — including total interest — of your current mortgage and your new loan would compare.

Take note that refinancing usually makes more sense earlier into your mortgage term.

In the early years of your mortgage term, your payments are primarily going toward paying off interest. In the later years, you begin to pay off more principal than interest, meaning you start to build up equity — the amount of your home that you actually own.

Once you refinance, it’s like you’re starting over. Say you’ve been paying off your old mortgage for 10 years, and you have 20 years left to go. If you refinance then into a new 30-year mortgage, you’re now starting at 30 years again.

Figure out whether you’re willing to invest the effort.

Refinancing, just like applying for a mortgage, can take significant time and effort. You may need to obtain additional paperwork and spend time understanding your options, so consider whether the savings you could receive make up for this extra effort.

Know where your credit score stands.

Since your credit can impact your interest rate, you should know what kind of shape it’s in. If it’s not in great standing, you may want to take steps to improve it before you refinance.

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