The average U.S. homeowner refinances his or her mortgage every four years. Sometimes it’s to take advantage of lower interest rates, but there are many other reasons to refinance your mortgage. Wondering when should you refinance your house? Find out by seeing if you can answer “yes” to one or more of the following questions.
Signs You Should Refinance Your Mortgage
1. Are interest rates rising?If you have an adjustable-rate mortgage (ARM) and expect interest rates to rise, you may want to switch to a fixed-rate loan. By locking in the interest rate, you won’t have to worry about your payments climbing in the future. On the other hand, if rates are rising and you have a fixed-rate mortgage, you’re in good shape. You may still have other reasons to refinance, but obtaining a lower rate isn’t one of them.
2. Is your monthly payment straining your budget?You may want to consider refinancing to lower your monthly payment.
Even if rates are the same as when you obtained your current mortgage, you may want to refinance to extend the term of your loan if you’re having difficulty meeting your monthly payments. For example, assume you have a $200,000 mortgage at 6 percent for 30 years and have been paying $1,200 a month for seven years. Refinancing to a new 30-year loan at the same rate would lower your monthly payment to $1,075.
3. Is your ARM causing stress?Perhaps you were attracted to an adjustable-rate mortgage because the initial rate and payments were lower than a fixed-rate loan. However, many ARMs are adjusted annually. That means if interest rates go up so too will your monthly payments. If you aren’t comfortable with this variance and would prefer the peace of mind of a consistent payment, consider refinancing to a fixed-rate loan or to another ARM with more favorable rate caps (limits on how much the interest rate can increase).
4. Has your credit rating improved?When you applied for your mortgage, perhaps you had little credit history or maybe even a blemish or two on your borrowing record. Your credit score was a big factor when your lender determined the interest rate on your mortgage. If you had a low or mediocre score that has since improved, you may now be eligible for a better rate if you refinance.
5. Have you recently begun to earn a higher income?Refinancing isn’t always about lowering your monthly payment. Maybe you’ve received a salary increase at work, or your spouse has recently returned to the workforce after staying home to raise a family. You may want to put that extra income towards your mortgage. Converting to a 15- instead of a 30-year amortization, for example, will pay it off much faster and save you tens of thousands of dollars in interest payments.
6. Has your home equity climbed above 20 percent?If you obtained your mortgage with a down payment of less than 20 percent, chances are you incurred Private Mortgage Insurance. However, if rising house prices have increased the value of your house, your home equity may now exceed 20 percent. If this is the case, you have several options. First, you can ask your lender to cancel your PMI. To do this, you’ll need to get an appraisal to prove that your home’s value has increased and that you have exceeded 20 percent equity. However, if you can’t persuade your lender to drop the mortgage insurance, you might want to consider the refinancing. If your new mortgage is for at least 80 percent of your home’s appraised value, you’ll avoid paying PMI and could save $100 a month or more.
7. Do you need to consolidate debt?If you have built up considerable equity in your home, but you’re mired in other debt, consider cash-out refinancing. That involves getting a new mortgage for a larger amount than you currently owe. For example, if your home is worth $285,000 and your outstanding principal is currently at $185,000, you have $100,000 in equity. By refinancing to a new mortgage with a principal of $215,000, you can free up $30,000 to pay down high-interest credit card or other debt. You’ll save money if your new mortgage has a lower rate than the other loans, and you’ll have the added convenience of only having to make a single monthly payment.
8. Do you need money for a major expense?Cash-out refinancing isn’t just for consolidating debt. If you have available equity in your home, it may enable you to undertake some major home improvements, or to free up money for your children’s education. If you do plan on taking cash-out, it's important to be realistic about your future goals. Remember that taking cash out will increase the principal you owe on your home. This may impact you when you go to sell your home.
Signs You Should Not Refinance Your Mortgage
Here are some signals that indicate refinancing may not be the right move for you:
1. You're not planning on owning the home for long
Because of closing costs, the economic benefit of refinancing generally boils down to a trade-off between short-term costs and long-term savings. Measuring that trade-off should allow you to identify your break-even point -- the point at which savings from refinancing have fully recouped the initial outlay you made in closing costs. However, measuring your true savings is not as simple as comparing your new mortgage payment to your old one. If you have lengthened your remaining mortgage term by refinancing, this spreads your principal prepayments over a longer period so short-term savings may be counterbalanced by paying off your loan over a longer time period. A more valid way to measure the break-even point is to compare the interest component of your payments before and after refinancing. To be even more accurate, you should adjust the resulting interest savings by your tax rate, to reflect the fact that mortgage interest is tax-deductible. The reason for calculating your break-even point is that if you are not confident you will own the home long enough to recoup your closing costs, you may not be in a position to benefit from refinancing.
2. You have poor credit
If your credit has deteriorated since you originally took out your current mortgage, this may be a significant obstacle to refinancing. Even if poor credit doesn't prevent you from being approved for a new loan, it is likely to cause you to have to pay a higher interest rate than the prevailing market average. This very well could negate any potential advantage you could reap from refinancing your mortgage.
3. You can't pay the closing costs
This is a bit of a Catch-22: people are often interested in refinancing because their finances are tight, but refinancing requires an upfront investment in the form of closing costs. Coming up with the money for those costs may not be possible if you are strapped for cash. One option in these situations is to finance the closing costs by adding them to the principal of your new mortgage. However, this means borrowing more than you currently owe, which will increase the amount of interest you have to pay.
4. Your real goal is to tap into your home equity
If this is the case, you may be better off taking out a home equity loan, especially if your current mortgage terms are more favorable than the terms available with refinancing now. Rather than reset the terms for both the principal you now owe and the new amount your borrowing, it would probably make more sense to leave your current terms intact and only subject your new borrowing to today's loan terms. On the other hand, if interest rates are lower today than on your existing mortgage, you can kill two birds with one stone by cash-out refinancing. This will both reset the rate on your current principal and allow you to borrow against home equity.
5. You are refinancing backward
What does "refinancing backward" mean? Well, start with the premise that the idea behind making mortgage payments every month is that you should be working towards paying down the loan over time. Now consider the following refinancing scenario. You buy a home with a 30-year mortgage, and then make payments for five years. At that point, you refinance into a new 30-year loan. If you refinance that way, you are no closer to paying off your mortgage today than when you first bought the house five years ago and you will increase the amount of interest you will have to pay over time since you are extending your loan payment term. The positive is that your monthly payments will now be lower since you are now paying off a smaller principal. Even with this benefit, when you refinance, a good goal is to get a new loan that is as short or shorter than the remaining time left on your current mortgage. Shorter loans may mean higher monthly payments, but they are less costly in the long run because they require you to pay interest for fewer years - and they generally feature lower interest rates than longer loans.
The answer to the question "should I refinance my home" may not come down to a single, definitive solution. Instead, you may want to draw up a list of pros and cons and look at the question from both angles so you can decide whether you have more to gain than to lose by refinancing.