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When to Refinance Your Mortgage: Finding the Right Time

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

A mortgage refinance provides you with a new mortgage that pays off and replaces your old one. Refinancing can lower your monthly mortgage payment, improve your overall loan terms or give you access to your home’s equity for a specific goal.

When to refinance a mortgage

It takes time and money to refinance a home loan, which is why it’s important to understand how you’ll benefit from the process.

Here’s when to refinance a mortgage:

You can get a lower interest rate

Let’s say you took out a 30-year fixed-rate mortgage five years ago. You started with a $200,000 loan, 4.5% interest rate and $1,013 monthly mortgage payment (principal and interest). You recently checked refinance rates and noticed you could get a new 30-year loan at 3.25% rate, lowering your monthly payment by more than $140.

You want to shorten your loan term

If you can pay off your mortgage much sooner due to an increase in your income, it might make sense to refinance into a shorter-term mortgage. The caveat: While you can secure a lower mortgage rate with a shorter loan term, you’ll have a higher monthly payment, since 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. If you’d like to refinance into a mortgage with better terms, you need to be better off financially than when you borrowed your existing loan. The best interest rates are typically reserved for those with at least a 740 credit score. On the other hand, the lower your DTI ratio — the percentage of your gross monthly income used to pay all your monthly debts — the less risky you are to lenders. Try to keep your ratio below 43%; it could help you snag a lower refinance rate.

You need to switch your loan type

Whether you have an adjustable-rate mortgage (ARM) and want the stability of a fixed-rate loan, or would like to switch from a Federal Housing Administration (FHA)-insured loan to a conventional loan, you’ll need to refinance to make the change.

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. Meanwhile, if you borrowed an FHA loan and put down less than 10%, you’ll pay mortgage insurance premiums for the life of the loan. Refinancing into a conventional loan helps you get rid of that extra monthly cost. You’ll need 20% equity in your home to refi into a conventional mortgage, though — otherwise, you’ll pay for private mortgage insurance on your new loan.

You want to tap your home equity

Perhaps you need to fund your home improvements or cover college costs. A cash-out refinance can help with those goals, but you’ll need at least 20% equity to qualify. Here’s an example: 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 a cash-out refinance, you can’t borrow the full amount, which limits your maximum loan-to-value (LTV) 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 of equity you can cash out of your home.

When should you wait to refinance your home loan?

Refinancing your home doesn’t always make financial sense, especially if you plan to move within a few years or have damaged credit. 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 recoup your refinance closing costs, you could end up losing money.
  • You’re close to paying off 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 charges. Consider sticking it out or choosing a shorter repayment term to achieve your refi goals.
  • Your credit score is struggling. A not-so-great credit score can bump up the refinance rate you’re quoted and cost you more money in the long run.
  • You need to focus on other financial goals. If the money you’ve set aside to refinance your mortgage could be used to pay down high-interest debt or beef up your emergency fund, consider prioritizing those goals first.
  • You could face a prepayment penalty. Some lenders charge you a hefty fee — known as a prepayment penalty — if you pay off your loan in the first few years of borrowing it. Your new loan pays off your old mortgage when you refinance, so if that would trigger a penalty, you’ll pay more than expected for your refi. You can find out whether your existing loan terms include a prepayment penalty by checking the first page of your closing disclosure.

5 things to consider before a mortgage refi

If you’ve determined when to refinance your mortgage, review the following considerations before starting 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 to determine how much time it’ll take you 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 50 basis points (0.5%) lower than your current rate.

Is there room for improvement in your credit score or DTI ratio?

Pull your credit reports 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 refi 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 you’ll have higher monthly payments and long-term interest costs.

Is refinancing worth it?

There are several factors to consider before you decide whether refinancing makes sense for your financial situation.

If you bought your home or last refinanced during a higher-interest-rate environment, or if you fit into one or more of the scenarios mentioned above, now could be a good time to consider refinancing your home. A mortgage refinance calculator can help you crunch the numbers.

When you’re ready to move forward, work with a mortgage lender who can look at your goals and identify exactly how you’ll benefit from a refi. Contact your current lender and gather refinance quotes from at least three additional lenders to discuss your options and find your best loan terms.

 

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