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When to Refinance Your Mortgage: Finding the Right Time

A mortgage refinance allows you to get a new mortgage that pays off and replaces your old one. Ideally, a refinance should result in lowering your monthly mortgage payment, getting better loan terms or tapping your home’s equity to achieve a specific financial goal. But how do you know when to refinance your mortgage?

There are several factors to consider before you decide whether refinancing makes sense for your financial situation. Read on for help determining when to refinance a home loan, including:

When to refinance your mortgage

The most common reasons for refinancing a mortgage involve reducing your interest costs or monthly payments. Refinancing your home loan takes time and money, so it’s important that you get some benefit out of the process. Here’s when to refinance a mortgage:

  • Interest rates fell and you can get a lower your monthly payment. Let’s say when you took out your existing mortgage five years ago, you took out a 30-year, $200,000 loan at a 4.5% interest rate and $1,013 monthly mortgage payment (principal and interest). Since then, you’ve checked refinance rates and noticed you could get a new loan at a 3.75% rate. If you’re able to get a rate lock, you could lower your monthly mortgage payment by nearly $170 with a new 30-year loan.
  • You want to shorten your loan term. If your income has increased to the point that you can pay off your mortgage much sooner, it might make sense to refinance into a shorter loan term. The caveat: While you can secure a lower mortgage rate with a shorter loan term, your monthly payment will be higher because there’s a shorter amortization schedule. Be sure your budget can handle the higher payments.
  • You have a higher credit score or a lower DTI ratio. Two major factors that affect mortgage rates are your credit score and debt-to-income (DTI) ratio. The better your credit score, the lower your interest rate. The best interest rates are typically reserved for borrowers who have a 740 credit score (or higher). On the other hand, the lower your DTI ratio — the percentage of your monthly debts in relation to your gross monthly income — the less risky you are to lenders. You’ll want to try and keep your debt-to-income ratio below 43%, which can help you snag a lower refinance rate.
  • It’s time to switch your loan type. Whether you have an adjustable-rate mortgage (ARM) and want the stability of a fixed-rate loan, or want to replace a loan insured by the Federal Housing Administration with a conventional loan, you’ll need to refinance to do so. Interest rates on ARMs can go as high as five percentage points above the initial rate when they adjust for the first time, which can make or break a loan’s affordability. If you put down less than 20% when taking out an FHA loan, you’ll pay mortgage insurance premiums for the life of the loan. Refinancing into a conventional loan helps you get rid of those payments. You’ll need 20% equity in your home to refi into a conventional mortgage, otherwise, you’ll pay private mortgage insurance on your new loan, too.
  • You want to use your home equity. Perhaps you’re looking for money to fund a home improvement project or cover college costs. A cash-out refinance can help with those goals, but you’ll need at least 20% equity in your home before refinancing. Here’s an example: Say your home is worth $200,000 and you owe $100,000 on your existing mortgage, giving you $100,000 in equity. Since you have to maintain 20% equity in your home after you do a cash-out refinance, you can’t borrow the full amount, which limits your maximum loan-to-value ratio — the percentage of your home’s value being financed by the mortgage — to 80%. Multiply $200,000 by 80% to get $160,000 then subtract your $100,000 loan balance to get $60,000. This is the maximum amount you can cash out of your home.

5 things to consider before refinancing your mortgage

Once you’ve determined your mortgage refinance goals, review the following considerations before you start the refi process:

  • How many years are left on your existing loan? If you have 20 years left on your current mortgage and decide to refinance into another 30-year loan, you’re restarting your amortization schedule and significantly increasing the interest you’ll pay over the life of the loan. Try refinancing to a shorter term if your budget can handle it.
  • How long do you plan to stay in your home? If you’re selling your home in a few years, refinancing may not benefit you as much as you think. Calculate your break-even point, or the time it takes to recoup your closing costs.
  • What’s the current interest rate environment? Mortgage rates are unpredictable, but if they’ve dropped enough to give you the savings you’re looking for in a refinance, you might want to act quickly. Aim for an interest rate that is more than 0.5% lower than your current rate.
  • Is there room for improvement in your credit score or DTI ratio? You can pull one credit report each year from Equifax, Experian and TransUnion for free at AnnualCreditReport.com and get a free credit score online. If you have time to improve your score or pay off debt to boost your chances of a refinance approval, it might make sense to wait.
  • How much does it cost to refinance? You’ll need to set aside funds to cover your refinance closing costs, which can range anywhere from 2% to 6% of your loan amount. You may be able to roll those costs into your loan, but a larger principal amount means a higher monthly payment and interest expense over time.

Is now a good time to refinance?

Now may be a good time to explore refinancing as interest rates have fallen more than a full percentage point since last fall. For example, the rate on a 30-year, fixed-rate mortgage most recently averaged 3.78%, according to Freddie Mac’s Primary Mortgage Market Survey. A year ago, the rate was 4.83%.

If you bought your home or last refinanced during a higher interest-rate environment, or if you fit into one or more of the earlier criteria mentioned, now could be a good time for you to refinance. Reach out to your current lender to discuss your options, and gather refinance quotes from additional lenders to find the best loan terms.

Use a mortgage refinance calculator to help you crunch the numbers.

When not to refinance your mortgage

Refinancing doesn’t always make financial sense, especially if you plan to leave your home within a few years or have experienced setbacks with your credit score. Here are some scenarios when refinancing your mortgage isn’t a good idea:

You’re selling your home soon. One of the most important calculations in a refinance is your break-even point. If you won’t stay in your home long enough to reach or make it past your break-even point to recoup closing costs, a refinance could end up costing you money.

You have only a few years left on your existing loan. If you’re in the homestretch of a mortgage payoff, starting the clock over with a new, long-term loan means you’ll pay significantly more in interest payments. Consider sticking it out or choosing a short-term fixed loan to achieve your refi goals.

Your finances or credit need work. A not-so-great credit score can bump up the refinance rate you’re quoted and cost you more money in the long run. Additionally, if the closing costs you’d pay on your refinance could be better used to pay down non-housing debt or beef up your emergency fund, consider prioritizing those goals first.

You could pay a prepayment penalty. Some lenders charge you a hefty fee — known as a prepayment penalty — if your loan is paid off in the first few years after taking out a loan. Your new lender pays off your old mortgage when you refinance, so if that would trigger a penalty, you’ll pay more for your refinance than expected. The first page of the Closing Disclosure of your current loan tells you whether your loan includes a prepayment penalty, or you can check with your lender directly.

The bottom line

Figuring out when to refinance your mortgage can be tricky but, ideally, you want to do it when you’ll receive a specific financial benefit.

Work with a lender who can look at your goals and identify exactly how you’ll benefit from a refinance — through a lower interest rate, monthly payment or shorter loan term, for example — before you move forward.

 

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