Should I Refinance My Mortgage?
In the mortgage businesses, refinancings are slowing down -- recently hitting an eight-year low. That reflects many years of ultra-low interest rates, when many homeowners took advantage of them to refinance. Interest rates have begun inching up now -- but that doesn't mean it's too late for you to refinance your own mortgage.
Refinancing is when you essentially trade in your current mortgage for a newer one -- ideally one with more attractive terms. The first loan gets paid off by the new one. Here are some reasons why it might be smart -- or not so smart -- for you to refinance your home loan.
When refinancing is a good move
There are a bunch of sound reasons to refinance a mortgage. Here are the main ones:
You want lower monthly payments : This is a key reason why many people refinance. If prevailing interest rates have dropped since you bought your home, you can lock in lower monthly payments by refinancing. One rule of thumb is that refinancing can be worth it if there's a difference of at least one percentage point between your current mortgage rate and the new rate you can get. As an example, the national average interest rate for a 30-year fixed-rate mortgage was recently 4.2% (up from 3.66% a year earlier). If your 30-year loan is carrying a rate of about 5.2% or more, refinancing can make sense. A Bankrate.com mortgage calculator reveals that a standard $200,000 loan will sport monthly payments of $1,098 at an interest rate of 5.2% but just $978 at 4.2%. That's a meaningful difference of $120.
Your credit score has increased significantly : Low credit scores keep home buyers from being offered great interest rates . If your score was on the poor side when you got your mortgage and you've improved it since then (perhaps by paying off lots of bills on time or paying off costly credit card debt in order to reduce your debt-to-income ratio), you may be able to refinance at a meaningfully lower interest rate -- even in an environment of rising rates. Check out the table below that shows what a difference a strong credit score can make:
Total Interest Paid
Source: MyFICO.com, as of mid-February 2017.
You want to shorten the life of your loan : If you have 24 years left on your original 30-year mortgage, but you're hoping to retire in about 15 years, it can make sense to refinance into a loan that will be paid off around the time you retire. Of course, a 15-year mortgage will sport steeper monthly payments than a 30-year one. Check out the sample loans below. (They use a constant interest rate, but know that shorter-term loans tend to have lower interest rates than longer-term ones.)
15-Year Monthly Payment
30-Year Monthly Payment
Source: Bankrate.com online calculator.
Note that if you're not completely sure you'll be able to make all the higher payments, there's a handy compromise. You could get a 30-year loan with no prepayment penalty, and then pay significantly more than your required payment each month. That way you can shave many years off the loan and avoid a lot of interest payments. If you're getting pre-approved for your mortgage or to refinance, make sure that your new loan doesn't include a prepayment penalty. If you're already in a 30-year mortgage with no prepayment penalty, you may not need to refinance at all -- you can shorten the life of your loan by just plowing more money into paying down your principal.
You want a different kind of mortgage : When you refinance, you can trade in one kind of loan for another. Perhaps, for example, you originally took out an adjustable-rate mortgage (ARM) that had an ultra-low rate for its first five years. Well, if those five years are up and interest rates seem to be rising, you might not want to face rising mortgage payments in future years. So you might refinance to a fixed-rate mortgage, ending up with payments that might be higher than what you face now, but that won't rise anymore. Similarly, if you know now that you won't be in your current home more than a few more years, you might refinance into an ARM with lower rates.
When refinancing is not advisable
Refinancing is not always the smart thing to do. Consider, for example, the following:
- If you don't think you'll stay in your home long enough to recoup the closing costs for the refinancing, then don't refinance. (Yes, refinancings have closing costs -- the process is very much like getting your initial mortgage.) If your closing costs are $2,400 and you'll be enjoying monthly payments that are $120 lower, then it will take you 20 months to break even. If there's a good chance you'll be moving in a year, don't refinance.
- If you're refinancing in order to take out some of your home equity, think twice. You'll often end up with a bigger loan balance than you had before refinancing, and less equity in your home, too. In exchange for that, you will get access to a bundle of money, but if you use it to remodel a kitchen or buy a new car, you probably won't come out ahead, financially. The car will start depreciating immediately, and most remodelings don't net you more than what they cost when you eventually sell the home. Taking on more debt means you'll be paying a lot more in interest.
- If you're refinancing to lower your payments by lengthening the life of your loan (perhaps by going from a 15-year loan to a 30-year one), be sure that you're OK with paying thousands more in interest and being in debt much longer. You might mitigate the downside of this move by enjoying lower payments but making a few extra ones throughout the year, which can reduce the life of your loan and save a lot in interest. Just be sure that your new loan permits prepayments.
- If you're refinancing in order to consolidate debt, perhaps because you'd like to pay off high-interest rate credit card debt with low-interest rate mortgage debt, think twice. It can be an effective strategy, but if you're saddled with credit card debt because you tend to spend beyond your means, then you're not likely to suddenly change your ways. You'll instead be taking on more long-term debt, while feeling unburdened by credit card debt and perhaps feeling freer to spend beyond your means again. That's a recipe for trouble.
Assess your situation carefully and consider refinancing's pros and cons. If it's the right move for you, you can end up saving tens of thousands of dollars.
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