When should I consider refinancing my mortgage?

Refinancing a loan refers to the process of taking out a new loan to pay off outstanding loans, typically at a lower rate of interest. Refinancing a mortgage is a major financial move that can result in significant savings. However, this strategy can also backfire, making it important to know the right situations in which you should refinance. Furthermore, it can cost between 2%-5% of a loan’s principal, requires an appraisal and application fees making it a significant decision. Refinancing makes sense only if you will end up saving money and it won’t cause new problems for you. However, there are several other considerations to be made, including risk management, your credit score, other financial goals, and your refinancing break even point. 

For many people, when mortgage rates nearly hit rock button or atleast fall below their current loan rate, it seems like a good time to refinance a mortgage. However, there are other good reasons to consider refinancing:

Refinancing to save money

Most online calculators will tell you a breakeven period based on cash flow indicating how long it will take to recoup any closing costs after accounting for a new (lower) monthly payment. However, you will usually need a more thorough review of how interest costs will change. To determine you’ll save money, you will need to run the numbers yourself. For example, if your current mortgage is a 30 year fixed rate loan of $200,000 with a 5% interest rate, you’ll have paid $48,076 in interest by year five and you will pay $186,512 in interest over the life of the loan. If you refinance after five years to a 3% fixed interest rate on a 30 year loan, you’ll only pay $95,252 in total interest on the new loan. Even added to what you paid so far on the old loan, you still come out ahead at $143,328 in total interest; a saving of $43,183. You can use an amortization calculator to make these calculations easier. 

Refinancing to cash out your equity

Sometimes homeowners tap into their home equity with a cash out refinance to raise funds to pay for other financial goals such as education or a new business. However, a cash-out can be risky because your house is now on the line, making it important to keep up with your new mortgage. 

Refinancing to consolidate your debts

You might also take cash out to consolidate high interest rate debts. This plan could be beneficial since home loan rates are usually much lower than credit card interest rates. However, if you refinance unsecured debts with a secured loan, you are taking additional risk. For instance, you might use a home equity loan to pay off a credit card debt. In the case that you default on the credit card debt and have pledged your home as collateral, your home might be foreclosed by the bank. 

Refinancing to shift from ARM to a fixed rate mortgage

In some cases, refinancing can be a good idea, even without a lower rate or a shorter term. For instance, if you are worried about increasing interest rates in the future, refinancing from an ARM to a fixed rate mortgage reduces that risk.

Things to watch out for when refinancing

If you are considering refinancing, do ensure to look into the following:

• Closing costs: These will add to the expense of your loan and could possibly reduce or eliminate any gains you’d have from lowering your interest rate. It could be tempting to add these costs into the loan balance, but it is recommended to pay them out of pocket so you do not have to pay interest on them too. 
• Prepayment penalties: Check your prepayment penalties terms and conditions. These are often charged to compensate for the time in which interest was not paid. 
• Changes in equity: Taking out or adding significant closing costs to your loan balance will reduce your equity in your property. However, if you just replace one loan with another loan of the same size, your equity remains the same. 
• Private mortgage insurance may be necessary if your home has lost value. 

Is it ever wise to consider refinancing with rising rates?

If rates are increasing, it might be better to consider refinancing now as opposed to later when they might be higher. First you’ll need to look at how far you are into your current mortgage and determine your Combined Loan to Value (CLTV) ratio which compares your loan balance to your home’s value and indicates all lines of credit that you may have open on your home. The lower the percentage is, the better. However, in general these are a few times refinancing during a period of rising rates can be a good thing: 

• Your ARM is about to reset: If you’re coming up on the adjustable part of your adjustable rate mortgage within the next year or two, switching loans means your rate would be guaranteed for longer than it is now. 
• Consolidating other loans: If you have multiple debt sources; other debts that have higher interest rates than home loans, it may be wise to consolidate so you are paying the same interest rate across all loans. 
• Your credit score improved: If you increase your FICO score, you could qualify for a less expensive loan. 
• You have money coming in: If you are expecting more money in your bank account, you can also expect a better debt-to-income (DTI) ratio, which will allow you to access better refinancing options. 

Conclusion 

Although every situation is different and must be evaluated independently, a few criteria can be considered before thinking about refinancing. Check if current interest rates are at least 1% lower, you plan on staying in your home for another 5 years and you anticipate being approved for the refinance loan based on your credit score. Do not jump into refinancing, because it can cost your home and compel you to compromise on other financial goals if it backfires. The final takeaway must be to figure out what your total costs, new monthly payments be and make a wise decision.