Whether you should refinance a mortgage comes down to the answers to these two questions: How much can you save, and can you recoup the cost of refinancing?
Homeowners may consider refinancing when interest rates drop. But with rates moving in the opposite direction, you may be asking yourself: When should I refinance my home?
Here’s how to answer that question.
[Read: Best Mortgage Refinance Lenders.]
What Is a Mortgage Refinance?
When you refinance a mortgage, you take out a new home loan with new terms and pay off your original loan. This can “put you in a better financial position as far as liability and cash flow goes,” says James Gaudiosi, a senior loan officer at Atlantic Coast Mortgage in Fairfax, Virginia. Homeowners may be able to:
— Get a lower interest rate and/or monthly payment, which frees up room in their budgets.
— Shorten their loan term, which reduces the interest they pay and could help them get out of debt faster.
— Switch from an adjustable-rate mortgage to one with a fixed rate for predictable monthly payments.
— Cash out a portion of their home equity.
The number of homeowners who are high-quality refinance candidates has decreased significantly since the start of 2022, according to mortgage technology and data providerBlack Knight.Black Knight considers homeowners to be refinance candidates if they could get an interest rate at least 0.75 below their current rate, among other terms.
Is Refinancing Worthwhile?
Refinancing a home can be a smart financial move, but you should evaluate your own situation. “Ideally, you would refinance only when there’s a benefit that offsets the cost,” says Nicole Rueth, producing branch manager with the Rueth Team of Fairway Independent Mortgage Corp. in Englewood, Colorado. “There’s a financial cost and a time cost. It’s an effort to compile all those documents and get the refinance done.”
Here are the top factors to consider:
How much interest you would pay. If you cut your interest rate with a new loan, you may pay less interest over the life of the loan compared with the remaining term on your original loan.
But even with a lower monthly payment, you could pay more interest if you stretch out the loan term. Calculate how much interest you would pay on the new loan compared with your current loan to see your potential savings. You can look into prequalifying for a loan to get an estimate of your new interest rate and other terms. You may decide to refinance even with a small rate cut, as long as you save money and have no plans to move.
A refinance may also be worthwhile if you can switch from an adjustable-rate to a fixed-rate loan. When you have an ARM, rising interest rates can cause your mortgage payments to increase after an initial period with a fixed rate. But getting a fixed-rate loan protects you from further hikes.
How long you’ll be in the home. Even if you can lower your monthly payment, refinancing might not make sense if you plan to move in the next year or two, Gaudiosi says. That’s because you won’t have much time for your interest savings to make up for the closing costs on the new loan.
Let’s look at one scenario. You would need 16 months to break even on a refinance if your closing costs are $8,000 but you save $500 on your mortgage payment each month. If you plan to stay in the house past the break-even point, refinancing might be worthwhile.
Some lenders may advertise mortgages with no closing costs, but those loans will have higher monthly payments than if you had just paid closing costs. Either the lender charges you a higher interest rate, or the closing fees are rolled into the loan, according to the Consumer Financial Protection Bureau.
How long you’ve already lived in your home. Consider whether you want to lengthen your loan term. “If you have 22 years left on the old mortgage and you refinance into a new 30-year mortgage, now you have eight more years of paying off a mortgage,” Gaudiosi says. “You’ve got to look at your ‘freedom point.’ When are you going to be able to pay it off?”
Other financial goals. If you’re putting the money you save toward another financial goal, such as paying off high-interest debt, the savings are twofold.
“I can redirect that $500 toward high-interest debt (and pay it off) over 12 to 18 months, for example, versus years and years of throwing $50 or $100 a month at it,” Rueth says.
Your home equity. When estimating your refinancing costs, the lender will check your home equity. That is the portion of your home that you own, calculated by subtracting your mortgage balance from your home’s market value.
Home values in the U.S. have gone up in recent years, according to the Zillow Home Value Index. That means your equity may have naturally increased. Generally, you will need to have at least 20% equity in your home and a loan-to-value ratio of 80% at the most to refinance.
Your credit score and debt-to-income, or DTI, ratio. Lenders use these metrics to help decide whether you qualify for a refinance. Has your financial situation improved since you closed on your original loan?
“You might have a homeowner who had a 660 score when they bought the home, and now their score is 740,” Gaudiosi says. “They’ll get better overall terms because their credit score has improved.”
But if your credit score has dropped and your DTI has increased recently, then it might be harder to qualify for an interest rate that results in savings. Prepayment penalty on your original loan. You’ll want to know whether you agreed to a prepayment penalty when you closed on your original home loan. This type of fee can apply if you pay off your mortgage within three years of taking out the loan.
Not all mortgages have prepayment penalties, and there is federal and state legislation that restricts them. If you owe a prepayment penalty, find out from your loan servicer when it’s due and how much it will cost.
[Read: Best Personal Loans.]
What Are Refinancing Alternatives?
When you can’t or don’t want to refinance a home loan, you have other options.
Personal loans. You could borrow under $1,000 or as much as $100,000, depending on the lender, your needs and your creditworthiness. Loan terms can range from a few months to multiple years, according to the CFPB. A personal loan could be a good option for paying off high-interest debt, which could boost your credit score, or for making home improvements, which could increase your home’s value.
These loans are usually unsecured, meaning you won’t have to pledge collateral to qualify.
Home equity loans or lines of credit. Tapping into your home’s equity is another option, but it carries the risk of using your home as collateral. The lender may foreclose on your home to satisfy the debt if you don’t repay it. A home equity loan is a lump-sum payment you repay over a certain number of years. A HELOC, on the other hand, gives you a revolving credit line you can borrow against and pay back during a draw period.
[Read: Best Home Equity Loans.]
When Should I Refinance My Home?
Maybe you’re looking to refinance a mortgage to make some room in your budget, but there are reasons not to refinance your home. Mainly, “you could come out spending more money and putting yourself in a bad position,” Gaudiosi says.
Refinancing can be a bad idea if you:
— Won’t save much on the refinance.
— Aren’t sure how long you’ll stay in your home.
— Don’t want to pay closing costs.
However, there are several reasons to refinance your home that make sense. A refinance can work in your favor if you:
— Can recoup your closing costs quickly.
— Avoid mortgage payment increases by switching from an ARM to a fixed-rate loan.
— Have a stronger credit score than when you first bought the home.
When Should You Commit to a Refinance?
Before you refinance, talk with a lender about your financial situation and get an estimate of your interest rate, loan term and monthly payment. Check whether you would recoup the costs of the loan, and consider what you plan to do with your monthly savings.
Yes, there is a lot to consider, but Rueth cautions against waiting too long to pull the trigger.
“The idea around getting a lower interest rate is this painful wait and see,” she says.
What to do if you’re still wondering, “Should I refinance?” Take the next step to confirm. Rueth says to ask yourself: “Is today’s interest rate going to save me money?”
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