How to Know When to Refinance Your Mortgage
Point of Interest
Believe it or not, mortgage loans don’t have to be a forever thing. Once you commit to a mortgage, you have the option to refinance down the line, which replaces your original mortgage with a new home loan that has different interest rates or loan terms.
As a homeowner, you may be under the impression that the mortgage loan you took out when purchasing your house is the mortgage loan you’ll have when your home is finally paid off. It doesn’t have to be, though — especially if your mortgage loan is leaving much to desire from the interest rate, the term or something else altogether. Plenty of people refinance their homes to take advantage of lower rates or the equity they’ve built in it, and if you’re unhappy with your mortgage, you can opt for that, too.
Still, while the option is there, it can be difficult to understand when you should choose a refinance. Most people look into refinancing when interest rates drop, but there’s plenty of factors involved in a refi beyond just interest rates. You can choose to refinance to borrow money from the equity you’ve built in your home or just to capitalize on lower interest rates or lower your monthly payments. If you’re thinking about refinancing your mortgage, there are several things to consider before you take the leap.
Most Common Reasons for Refinance
The reasons for refinancing will vary based on individual needs and goals, but in general, homeowners should consider a refinance if one of the following scenarios qualifies:
- To get rid of private mortgage insurance
- To lower interest rate significantly (the general rule is 1 to 2 points minimum, though you can make the case for refinancing with less than a full point savings by using a mortgage refinance calculator)
- To better afford the loan by saving on monthly payments
- To cash out equity for large bills or home renovation projects
- To refinance to a shorter term to pay off loan faster
- To change from an adjustable-rate to a fixed-rate loan
Tip: In some cases, once you build up 20% equity in your home, you may be able to refinance to get rid of the mortgage insurance from things like federally backed loans.
When should you refinance?
Many borrowers opt to refinance for two main reasons: either to lower their interest rate or to change the length of their loan term. For example: Let’s say you took out a 30-year mortgage with an interest rate of 3.500%, and five years later, interest rates have dropped to 3.000%. You could refinance your mortgage so that your interest rate is 3.000%, saving you on money on interest over the life of your loan.
On the other hand, if you take out a 15-year fixed-rate mortgage when you first purchase your home and then find yourself struggling to make your mortgage payments, you may need to prioritize lower payments over a lower interest rate with a refinance. You could refinance the original 15-year mortgage and replace it with a 30-year mortgage, which would give you more time (and lower monthly payments) to pay off your loan.
But in this scenario, because you’ll be paying your mortgage off for a longer period of time, you’ll pay more in interest over the life of the loan. Still, your monthly payment will be lower, which may make refinancing and paying more in interest worth the cost, since it will make it easier to manage from month to month. This can be especially helpful if you have other debts or priorities that you’re paying each month and you need some breathing room in your budget.
A refi also makes sense if you’re looking to switch from an adjustable-rate mortgage to a fixed-rate mortgage. An ARM mortgage is a loan that has a fixed interest rate at the start of the loan and then the interest rate fluctuates annually once the fixed term is over. ARMs usually offer lower starting rates, but have the potential to affect your monthly payments with higher (or sometimes lower) interest rates after a certain number of years.
For example, if you buy a home and think you’ll sell it within five years, a 5/1 ARM might make sense to you because you’ll get the low fixed rate for the first five years of the loan. If you later decide you want to stay in your home past that initial five-year stint, it could be wise to opt to refinance to a fixed-rate mortgage, which can prevent you from dealing with fluctuating interest rates.
What does refinancing cost?
Refinancing does involve closing costs — just like it did when you took out your original mortgage loan. Closing costs usually range from 2% to 5% of the principal amount of the loan. However, your lender may give you the option on your refinance to add these costs in with the principal so that you don’t have to pay them upfront.
It’s important to note that if the cost of refinancing is too high, it may not be worth it — even if your mortgage loan rate is dropping significantly with the refinance. Or, if you’re likely to sell your home before the cost of refinancing pays for itself, you may want to hold off.
Let’s say, for instance, that you want to refinance your 30-year mortgage loan to save money over the long haul, and the new loan drops your interest rate from 3.5% to 3.0%. If your mortgage loan has $150,000 left on it. If you were to stick with the 3.5% interest rate, you’d end up paying about $92,484.13 in interest over the life of the loan. If you refinanced to 3.0%, you’d pay about $85,432.80 in interest over the life of the loan.
That’s a savings difference of $7,051.33 over the life of the loan. So, in that case, you’d need to have closing costs less than $7,051.33 if the goal was to save interest over the long term. Otherwise, the overall savings would be negated.
But, if your goal was to save money on your payments each month, refinancing from 3.5% to 3.0% might still make sense — even if the closing costs negated the total savings. At 3.5%, a loan for $150,000 would cost you about $673.57 over the life of the 30-year loan. But if it dropped to 3.0% interest with a refinance, your monthly payments would be about $632.41 over the life of the loan. That’s a savings of about $40 less, give or take a few cents, each month.
If you’re trying to figure out whether a refinance would make sense for your needs, you can use this mortgage refinance calculator to determine whether the numbers work for your needs.
The final word
Refinancing your mortgage can save you a significant amount of money under the right circumstances, but everyone’s mortgage and needs are different. Having a clear goal in mind can help you make sure your refi is worth the cost of closing and the hassle of going through the mortgage lending process a second time.
Two important factors to consider when making the decision are your goals and how long you’ll be in your home. Refinancing often makes the most sense for borrowers who aren’t going to sell their home soon, since it takes time for the interest savings to be worth the extra closing costs. Whether you’re looking to save with a lower interest rate or lower your monthly payment with a longer term, having a plan can help you know when the timing is right.