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Have you ever thought about refinancing your home? Most homeowners I know have entertained the thought at one time or another. They think it’s probably a good idea, but don’t know if it makes sense for them or not. Mortgages are confusing already. Refinancing adds to the confusion and if you don’t know what you’re doing, it can cost you big time. Let’s look at when it makes sense to refinance your mortgage and when it’s a bad idea.
What is Refinancing?
Refinancing is when a loan is paid off and replaced with a new one. Often, the new loan will have a different rate and different terms. Each lender has a different approval process and fees associated with refinancing. People refinance a mortgage for many reasons, like securing a lower interest rate, shortening the terms of their mortgage, converting to a different type of mortgage and other reasons.
There are closing costs associated with refinancing a mortgage, just like when you bought your home originally. Some of the closing costs include:
- Loan Application fee
- Loan Origination fee
- Home Appraisal fee
- Home Inspection fee
Closing costs add up quickly and can be the difference in whether you will save money on your refinance or not.
When it Makes Sense to Refinance Your Mortgage
The decision to refinance your mortgage can have a huge effect on your finances. It’s not always the best idea, but there are times when it does make sense to refinance.
1. Refinance your mortgage to secure a lower interest rate
Perhaps the biggest reason that people choose to refinance their mortgage is to get a lower interest rate. When mortgage rates drop, there’s the potential of major savings in interest payments over the life of your mortgage. It can also lower your monthly payments. If you can lower your interest rate 1 to 2%, refinancing is worth exploring.
2. Refinance your mortgage to shorten your loan terms
If you have a 30-year fixed-rate mortgage, you can refinance your loan to shorten your terms. Because you will have a lower interest rate, you can often cut your terms in half to 15 years with little change to your monthly mortgage payment. By doing this, you’ll get the lowest rate possible.
3. Convert to an Adjustable-Rate or Fixed-Rate Mortgage
Many people refinance to switch from a fixed-rate mortgage to an adjustable-rate mortgage (ARM). With an ARM, the interest rate is locked in for a set amount of time. When that period of time ends, the rate changes once each year for the remaining life of the loan.
If mortgage rates are dropping and you suspect that trend to continue, refinancing could be a smart move. This is also true if you plan on moving soon and don’t need the stability of a fixed-rate mortgage. Be aware that if rates start to rise, your ARM will most likely go up as well.
4. Refinance your mortgage if the value of your home has increased
Home values can increase and if that happens, you can benefit from refinancing. You can take out a new mortgage that is larger than what you owed on your original mortgage. You receive this difference in cash. This is called a cash-out refinance.
Why would someone want to do this? Because they can use that cash to pay off other high-interest debt, to invest or to pay for home improvements. You’ll want to compare the new mortgage interest to the interest you pay on the other debt you’re paying off. A cash-out refinance is an alternative to a home equity loan.
When it Doesn’t Make Sense to Refinance Your Mortgage
You might be thinking you want to refinance your mortgage because you want that low rate, which is great. But there are some scenarios where refinancing isn’t ideal. When is refinancing your mortgage a bad idea?
1. When your break-even point is too large
Every refinance will have a break-even point. This is the point where you will recuperate those closing costs you paid for refinancing your home. To determine your break-even point, take your closing costs and divide by your monthly savings on your mortgage payments. For example, if you paid $2,500 in closing costs and knocked $100 off your mortgage payment, it would take you 25 months to break even.
If you start crunching numbers and realize it’s going to take a long time to start seeing any savings, refinancing might not be right for you. If you’re not planning on living in your house past the break-even point, refinancing just doesn’t make that much sense.
2. You’ve been paying on your mortgage for a while
With any loan, part of your monthly payment goes towards paying off your loan balance, or principal, and the other part pays interest costs. At first, most of your money is going towards paying interest. As you continue to pay down your mortgage, more of your payment will go towards the principal. This is called amortization.
As I mentioned, when you refinance your mortgage, your old loan is paid off and you get a new one. When you get your new loan, you have to start the amortization process over again. You’ll go back to paying more interest at first. Your monthly mortgage payment will probably be lower, but you’ll be paying less on the principal. If you’ve been paying on your mortgage for a long time, the thought of going back to mostly interest payments again doesn’t sound that appealing. And you would be right.
Tips for Refinancing Your Mortgage
If you are planning to refinance your mortgage, here are some tips to help you along the way:
Why are you refinancing?
Knowing the “why” behind any financial decision is key.
- Why do you want to refinance your mortgage?
- What’s the purpose behind doing it?
- Are you trying to create more monthly cash flow?
- Do you want to pay off your home faster?
- Are you trying to fix a bad mortgage loan?
Determining why you want to refinance will help clarify what success looks like. Then you can look at the numbers and determine if refinancing is the right way to achieve your goal.
Shop interest rates
Now comes the fun part: finding a good interest rate. How do you do that? You can spend tons of time with local banks and lenders or searching online.
The best tool I’ve come across is LendingTree. They are the largest online lending marketplace. Lenders compete for your business, which means the lowest possible rates for you! Simply answer some questions about your current situation and what you’re looking for and LendingTree will send you offers from lenders best suited for your needs.
Don’t forget about fees
You want that lower interest rate, but don’t forget to factor all those closing costs into your calculations. They could negate any savings you get from a lower rate if you aren’t paying attention.
As you move forward, does refinancing your mortgage make sense for you? Will it ultimately lead to savings and to meeting your financial goals? Take time to look at your current financial situation and research what’s available to you through refinancing. This will help you make a sound decision with your home mortgage.