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Most people think of mortgage refinancing as a sure way to take advantage of lower interest rates, but it's only worth doing so if the amount you save on monthly payments will be enough to earn back the extra closing costs by the time you move out. Many people consider refinancing as a way to cut out mortgage insurance or access extra cash by adding to their loan balance.
- When Should You Consider Refinancing Your Mortgage?
- Refinancing to Lower Your Expenses
- Eliminating Mortgage Insurance
- Cash-Out Refinance Mortgages
When Should You Consider Refinancing Your Mortgage?
Since mortgage refinancing is usually meant as a way to save money on the cost of your home payments, it's important to consider how a switch will affect your monthly payments and lifetime costs. You should consider refinancing when:
- Interest rates are down, and you plan to stay in your home for the long term
- You currently have a mortgage with permanent mortgage insurance
- You want to tap into the equity of your home with a cash-out refinance
We recommend you figure out how many monthly payments it will take before the monthly savings from refinancing will break even with the required closing costs. For example, a 30-year mortgage at 5% with an initial balance of $200,000 requires monthly principal and interest payments of $1,074. After about 10 years, you would have just under $163,000 left on your balance. If you decided to refinance and found a 20-year mortgage with an interest rate of 4% for that amount, you would pay $986, saving $88 each month on principal and interest.
|Original Mortgage||Refinance Mortgage||Difference|
|Term Length||20 years||20 years||-|
|Monthly Principal and Interest||$1,074||$986||$88|
If closing costs on your new mortgage end up costing a typical 3% of the loan balance, you would pay $4,880. Dividing that upfront cost by your monthly savings of $88 gives us a break-even time of 4 years and 8 months. If you were to sell your home before that time, then your refinance decision would cost more money than it saves.
Refinancing to Lower Your Expenses
When rates go down, you can think about refinancing in order to shave some points off your interest rate and get a lower monthly payment. However, refinancing will require you to pay a new set of closing costs, so it's important to calculate how many monthly payments you'll need before your savings will cover the closing costs of a refinance mortgage. If you want to pay off your mortgage earlier, you can also save money by refinancing into a shorter term.
For instance, you might want to pay down your mortgage more quickly by moving from a 30-year mortgage into a 15-year term. If rates have gone down far enough, you may be able to secure a similar or lower monthly payment even though you're compressing your repayment into a shorter timespan. If you're in an adjustable rate mortgage, be aware that many ARMs start changing their rates after a fixed-rate period of several years. Switching to a fixed rate mortgage can help you avoid the increases you might see by staying in your current ARM loan.
Alternatively, if you're simply trying to reduce your monthly mortgage payment, but wish to keep your interest rate and term the same, your lender may allow you to recast your mortgage by contributing a lump sum payment and a nominal fee.
Eliminating Mortgage Insurance
If your initial down payment was low enough to require mortgage insurance, refinancing is also a way to eliminate the added cost of that coverage. Because mortgages with smaller down payments pose a greater risk for the lender, they require the borrower to pay for mortgage insurance, which protects the lender in case of default. Borrowers either pay monthly premiums or accept a higher interest rate and let the lender pay for insurance.
While lenders legally must remove mortgage insurance premiums once a borrower pays off a certain amount, lender-paid insurance never goes away. If you chose to incorporate your mortgage insurance costs into a higher interest rate, the only option to remove that cost is to refinance. The same applies to FHA loans, which sometimes require insurance premium payments for the entire life of your mortgage.
Cash-Out Refinance Mortgages
Cash-out refinancing is a good option when rates are low and you feel comfortable with adding to your outstanding balance in exchange for immediate cash. When done appropriately, a cash-out can be a convenient way to obtain the funds needed for major expenses like home improvement or consolidating personal debt. This is particularly helpful if you have high-interest debt that would be cheaper to repay as part of your mortgage.
However, taking on extra debt with your home as collateral poses obvious risks. A cash-out refinance will set you back on the road towards final repayment, and if your home depreciates in value, you might end up owing more than what your property will sell for. Just like standard refinancing, cash-outs come with extra closing costs that will eat into the cash you withdraw. Finally, you may find that the interest rates offered for cash-out refinancing run higher than those for standard mortgages.