Mortgage refinancing basics
Your mortgage may have a 30-year term, but not many homeowners stay with the same loan for that long. In fact, the average American refinances his or her mortgage every four years, according to the Mortgage Bankers Association. That’s because paying off your present mortgage and taking out a new one can mean big savings over several years. However, mortgage refinancing comes with a price in the short term, so it’s important to consider both the costs and benefits before making your decision.
Here are some reasons to consider mortgage refinancing:
- To obtain a lower fixed rate. If you took out a fixed-rate mortgage several years ago and interest rates have since dropped, refinancing may lower your payments considerably. A $150,000 mortgage with a 30-year term and a rate of 8 percent, for example, carries a monthly payment of $1,100. The same mortgage at 6 percent will have a payment of less than $900 a month.
- To switch to a fixed rate or an adjustable rate mortgage. Adjustable-rate mortgages (ARMs) offer lower interest rates initially, but some homeowners find the fluctuations stressful. If rates are on the way up, you might consider locking in at a fixed rate and consistent monthly payment. On the other hand, if you want to reduce your monthly payments and are comfortable with the interest rate changes of an ARM, it could save you money to refinance to an ARM.
- To improve the features of your ARM. Mortgages with adjustable rates have protective caps that limit how much your payments can increase in any given year and over the full term of the loan. You may be dissatisfied with the caps on your current ARM and feel you can negotiate more favorable features if you refinance.
- To build your home equity faster. If a recent change in your financial situation has made it possible for you increase your monthly payments, you might want to refinance your mortgage with a shorter term. The higher payments will enable you to pay off your home more quickly and to save substantially on long-term interest charges. However, if you are disciplined you can also opt not to refinance and simply pay more towards your principal each month.
- To reduce your monthly payments. Refinancing for a longer term will lower the amount you have to pay each month. You will end up paying more in interest charges over the life of your loan, but if you’re having difficulty making your current payments, this strategy could provide some relief.
- To turn home equity into cash. You may want to take out a new mortgage with a larger principal, in order to turn some of your home equity into cash for a major expense. This is called cash-out refinancing. The advantage of taking out a loan secured by your home is that you can get a lower rate of interest than you can with an unsecured loan or credit card. However, if the interest rate offered for your refinanced mortgage is higher than your current rate, a home equity loan or line of credit might be a better choice.
Is mortgage refinancing right for you?
If you’re refinancing in order to pay less interest, you won’t usually see the savings right away. That’s because lenders typically charge fees when you take out a new mortgage, and you may also have to pay a penalty for getting out of your old one. To determine whether refinancing makes financial sense for you, consider these issues:
- How long you plan to be in your home. If you expect to move in a year or two, you may never realize the potential savings you’d get from refinancing. As a rule of thumb, the longer you plan to stay in your current home, the more sense it makes to refinance.
- The prepayment penalty on your current mortgage. Many mortgages carry a penalty if you pay them off early. The amount varies, but it is usually a small percentage of the outstanding balance, or several months’ worth of interest payments.
- The costs of the new mortgage. When you take out a new loan, your lender may charge a number of fees including application, appraisal, origination and insurance fees, plus title search, insurance and legal costs that can add up to thousands of dollars. Lenders may also charge discount points, which are paid upfront to secure a lower interest rate. As a guideline, expect fees to eat up any potential savings unless your new interest rate is at least a half a percentage point lower than your current one.
- The true difference in borrowing costs. When you’re considering refinancing, remember that the posted interest rate doesn’t reflect the entire cost of the mortgage. The amount you pay over the life of the loan will also be affected by the length of the term, whether your rate is adjustable or fixed, whether you paid discount points, and what upfront and ongoing fees you incur. One way to compare mortgage costs is to look at the annual percentage rate (APR), which takes into account not only the base interest rate, but also points and other charges. All lenders must follow the same rules when calculating the APR, so it’s a good basis for comparison.
- Your reduced tax savings. If you claim mortgage interest on your tax return, refinancing to a lower rate will mean that you’ll have less mortgage interest to deduct. You will still save money overall, but your real savings from refinancing may not be as large as you first believed. Consult a tax advisor who can help you understand the tax implications of refinancing.
The break-even point
In the end, deciding whether the cost of mortgage refinancing is worth it comes down to a simple question: “How long will it take before I start to save money?” In theory, this is a simple calculation. You start with the amount you will save by lowering your monthly payment. Then you add up all the costs associated with refinancing and divide the total by your monthly savings. This will reveal the number of months it will take to reach the break-even point.
For example, let’s assume that refinancing would lower your payment from $1,000 to $800 (for a savings of $200 per month) and your prepayment penalty, closing costs and points add up to $5,000. Divide $5,000 by $200 and you’ll see that it would take 25 months to realize the savings.
In reality, however, your break-even point also depends on other factors, including your tax situation and whether you pay closing costs upfront or add them to the principal of your new mortgage. If you are refinancing and your home has appreciated in value, you may also be able to save by canceling your private mortgage insurance.
For a more accurate estimate, use our refinancing calculator. Or consult a financial advisor who is familiar with your tax situation.
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