With all the chatter about the Federal Reserve’s September rate cut, you might be wondering if you should refinance your mortgage or even wait for steeper rate cuts in the future. In reality, mortgage rates have already fallen significantly, and it’s difficult to predict how much further rates will fall and how long that may take.
No matter what’s going on in the news cycle, 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 mortgage refinancing isn’t always worthwhile. Here’s how to determine if it makes sense to refinance your mortgage.
[Read: Best Mortgage Refinance Lenders.]
When to Refinance Your Mortgage — and When Not To
When you refinance a mortgage, you take out a new home loan with new terms and pay off your original loan.
Generally, it makes sense to refinance your mortgage if you can lower your interest rate by 1 percentage point or more — like going from a 7% rate to a 6% rate — but there are exceptions. You’ll also want to consider the up-front cost of refinancing and weigh that against how long you’ll stay in the home to calculate your break-even point.
Refinancing might be a good idea if you:
— Get a lower interest rate that saves you enough money to offset up-front closing costs.
— Shorten your loan term, which reduces the interest you pay and could help you 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 your home equity.
— Remove a co-borrower from the loan.
On the other hand, refinancing won’t always work in your favor: “You could come out spending more money and putting yourself in a bad position,” says James Gaudiosi, senior vice president, sales manager and senior loan officer at Atlantic Coast Mortgage in Fairfax, Virginia.
Refinancing might be a bad idea if you:
— Can’t save enough money in interest to offset the up-front closing costs.
— Aren’t sure how long you’ll stay in your home.
— Extend your loan term, which will cost you money and keep you in debt for longer.
— Cash out too much equity, since a drop in home prices could leave you underwater on your mortgage.
Is Refinancing Worthwhile?
Refinancing a home loan 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, branch manager and senior vice president with the Rueth Team of Movement Mortgage in Denver. “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 Can Save
If you cut your interest rate with a new loan, you may pay less interest over the life of the loan and pay down your principal balance faster.
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 word of caution: Stretching out the loan term will lower your monthly payment, but it will cost you more money in interest over the long run, and you’ll make slower progress on paying down the loan’s principal balance, thanks to the way a mortgage amortizes.
“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.
[Calculate: Use Our Free Mortgage Calculator to Estimate Your Monthly Payments.]
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. That’s because you won’t have much time for your interest savings to make up for the closing costs on the new loan.
Consider this scenario: Let’s say you can reduce your interest rate from 7% to 6% by refinancing a $300,000, 30-year mortgage, and the up-front closing costs are $6,000. It would take you about two years to reach your break-even point, and you’d lower your monthly payments by $200.
If you stay in the home for much longer, then the savings become worthwhile. By the 10-year mark, you will have saved $13,000 in interest — or $7,000 once you subtract the cost to refinance.
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.
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, and as long as you’ve been paying down your loan’s principal balance, your equity should have also increased. Generally, you will need at least 20% equity in your home and a loan-to-value ratio of 80% at the most to refinance.
Your Credit History
It might make sense to refinance if you’ve improved your credit score or debt-to-income, or DTI, ratio since buying your home. Lenders use these metrics to help decide whether you qualify for a refinance.
“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.
[Read: What Credit Score Do You Need to Buy a House?]
Prepayment Penalties
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 early within three years of taking out the loan.
Not all mortgages have prepayment penalties, and there are federal and state laws that restrict them. If you owe a prepayment penalty, find out from your loan servicer when it’s due and how much it will cost.
More from U.S. News
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Complete Checklist of Documents Needed for a Mortgage
Personal Loan vs. Home Equity Loan: Which Is Better?
With Mortgage Rates Dropping, Should You Refinance? originally appeared on usnews.com
Update 09/27/24: The story was previously published at an earlier date and has been updated with new information.
