When Does It Make Sense to Refinance?
Know the Break-Even Point and Interest Costs for Your Situation
Refinancing your mortgage can seem like an appealing prospect. You have the potential to decrease your monthly payments, pay off your mortgage sooner, or maybe even cash out some of the equity in your home. But closing costs and fees can quickly eat into any savings you might hope to get, leaving you right where you started—or even behind.
There are some situations when refinancing your home loan definitely makes sense—you just have to do the math.
Knowing When You'll Break Even
When trying to decide if refinancing is a good idea in your situation, it helps to calculate your break-even point. This analysis allows you to figure out how long it will take to recoup the costs you’ll pay to refinance. For example, assume you’ll pay $2,000 in closing costs and fees for a new loan, and your new payment will be $100 per month less than you pay now. In this scenario, you won't break even on the deal for 20 months, and then you'll start to come out ahead by $100 each month.
Most people who use this approach suggest that it makes sense to refinance if your break-even point is within two years or so. This calculation is especially useful if you don't plan on staying in your home for long.
Closing costs for a refinance will usually be between 3% and 6% of the loan's principal. Keep in mind that costs and fees may vary somewhat from lender to lender and even from loan to loan, so take that into account when doing your calculations.
Switching Between an ARM and a Fixed-Rate Mortgage
One of the times it may make sense to get into a different mortgage is to switch between an adjustable-rate mortgage (ARM) and a fixed-rate one. ARMs can wind up with higher interest rates than fixed-rate mortgages, even if their introductory rates are lower. Those low intro rates can mean a borrower is caught by surprise later when their monthly payments go up along with their rates. Refinancing an ARM to a fixed-rate 15- or 30-year mortgage can eliminate uncertainty surrounding variable rates and lower payments, too.
On the other hand, when mortgage rates are plummeting, it might make sense to switch from a fixed-rate mortgage with a high interest rate to an ARM that can take advantage of new lower rates. A refinance of this sort is better suited to homeowners who plan to sell before rates bounce back up again.
Reducing Your Mortgage Term
Refinancing allows a borrower to pay off their home sooner, shaving years (even a decade or more) off their loan. They also can take advantage of the lower overall interest costs of a shorter-term loan. That's because a mortgage spread over 30 years will cost more in interest than one spread over 15 years. For example, $200,000 borrowed over 30 years at 4% will cost $143,739 in interest alone. The same mortgage over 15 years will cost $66,288 in interest. So for a homeowner looking to reduce their interest costs and get out of debt sooner, refinancing to a shorter term makes sense.
Getting a Better Rate
Mortgage rates fluctuate frequently and can be affected by many factors, from your credit score to the Federal Reserve's economic policy. If the rate you qualified for when you originally bought your home is significantly higher than what you could obtain today, you could save money by refinancing.
The general rule of thumb when refinancing for a better rate is to hold off unless you can save one or two percentage points off your current rate. That ensures that the deal you're getting is good enough to make up for the closing costs on a new loan.
When to Be Cautious About Refinancing
In some cases, it's not a good idea to refinance. For example, sometimes your total interest costs will increase—even if your monthly payment decreases. This is especially true if your new loan has a longer term, such as a 30-year mortgage.
To understand why this can happen, it helps to know how amortization works. Each time you make a monthly payment, part of your payment goes toward the principal you borrowed, and part of it is your interest cost. In the early years of your loan, most of each payment goes toward interest, barely making a dent in the principal.
If you keep your old loan, more and more of each payment will go towards reducing the loan balance over time. But if you scrap your old loan for a new one, you go back to the beginning of the amortization process, and back to most of your payments going toward interest. If you had a 30-year mortgage and refinanced after 10 years to another 30-year mortgage, it's a little like resetting the clock—now you'll be paying on your home for a total of 40 years.
You may pay a few hundred dollars less each month if you refinance, but it can cost you tens of thousands of dollars more in interest over your lifetime.