Given how quickly mortgage rates are falling, one can easily assume that homeowners should refinance their loans, correct? While that is an option to consider, it’s not always the best move. To be honest, refinancing should only be considered when the time is right. In this article, we’re going to talk about when to refinance a mortgage and when you shouldn’t.
What is Mortgage Refinancing?
The process of mortgage refinancing is when homeowners seek out a new home loan to replace the one that they have. If homeowners are able to refinance to a loan that comes with a lesser interest rate, they can save money. Of course, this involves considering the best time to refinance. Simply put, this is when interest rates go below the level when the original mortgage was first closed. Besides this, another great time to refinance is when the credit improves to the extent when homeowners qualify for a brand new loan that comes with a lower interest rate.
A general rule of thumb for considering a refinance is to have your interest rate lowered by half the percentage point, and if you’re planning to remain in your property for a couple of more years.
When to Refinance a Mortgage
Lowering Interest Rates
Arguably, the biggest reason homeowners refinance their home loans is to lower the interest rate in their monthly mortgage payments. This type of refinancing is also known as “rate and term” refinance. This is a great benefit to homeowners who are dealing with high-interest rates on their ongoing loan, especially if they’re able to shorten their loan term.
As of now, the present-day economy is in a low-rate situation. And despite the fact that the connection between the mortgage rates and the Federal Reserve’s target rate is complicated, low rates means that it’s less expensive to borrow money and could offer homeowners a way to come out of their debt faster.
Mortgages with shorter terms typically come with lower interest rates than those of longer-term mortgages as the loan will be paid back in a fraction of the time it usually does, except that the monthly payments will possibly escalate. And if there’s room in their budget, a rate and term refinance could provide homeowners with big potential savings.
Getting rid of Mortgage Insurance
If your home loan is paired with private mortgage insurance (PMI), then refinancing your mortgage can lower monthly costs. This is according to Columbia-based mortgage lender Home Financial co-founder Dan Snyder
This is indeed the case if the loan is insured by the Federal Housing Administration (FHA). Although FHA loans are a viable option to help homeowners with a not-so-decent credit score or little savings, they come with a huge pitfall: mandatory mortgage insurance. Once an upfront premium of the loan amount, which is 1.75% has been paid, many FHA borrowers still pay an annual mortgage insurance premium of that amount, which is 0.85% for the next 30 years and it can’t be canceled. What’s even worse is that the amount continues to accumulate over time.
So to get rid of the PMI, homeowners refinance the FHA loan into a traditional mortgage once they have acquired 20% equity in their house.
Consolidating Debts of Higher-Interest
Homeowners who have accumulated a hefty load of high-interest debt on personal loans or credit cards, a cash-out refinance can help them save money and improve their overall cash flow in the long term. This is even possible even if their mortgage rate is only slightly higher.
The only problem with this option, according to the IRS, is that homeowners cannot deduct the interest rate that is paid on the cash-out amount that surpasses the ongoing loan balance if the funds haven’t been used to either purchase, construct or improve their house substantially.
Another thing to consider is that homeowners are securing credit card debt that is unsecured with their house. Hence, you should be careful as you proceed with this option. Ensure you can afford the new terms in order to avoid the event of your house being repossessed.
Why Refinancing could be a Bad Idea
In spite of the aforementioned benefits, however, there are a couple of downsides to refinancing your mortgage. Those downsides include:
Bigger Long-term Costs
Talk to your mortgage or bank lender about what refinancing could do to your bottom line in the long run. Although it’s a good idea, in theory, to lower monthly payments when it comes to refinancing, it could pose a threat to your pocketbook sometime later. In other words, if it’s costing you more just to refinance, then it wouldn’t make sense to operate now, would it?
For instance, if you’re already a number of years into your 30-year mortgage term, it means that you’ve already paid plenty of interest without making a difference in your principal balance. Refinancing to a 15-year mortgage term may reduce your interest rate, but could also increase your monthly payments, perhaps even to the point where it’s impossible for you to afford it. And even if you were to start a brand new 30-year mortgage, you’re typically starting with just as much principal as you had with your ongoing mortgage. Paying more despite having a lower interest rate, could very well mean that your long-term savings are pointless or perhaps the loan might cost you more down the line.
You Won’t be Staying for Long
When thinking about “when should you refinance your home?”, the break-even point needs to be considered. It’s the time that it takes homeowners to have their closing costs recovered on the brand new mortgage loan. To calculate the break-even point, you need to consider how much the closing costs are.
Closing costs average between 2-5% typically, which thereby takes homeowners several years before they can get back to even. If you’re paying about $4,000 in closing costs and the monthly payments only drop by $80, then it might take 50 months before you’re able to reach the break-even point. And if you’re going to move right before you break even, then it wouldn’t make much sense to consider refinancing as you might not be able to reap any of the essential financial benefits in the long run.
Closing Costs Unaffordable
When opting for refinancing, you have to pay the closing costs from your pocket. Sometimes, homeowners can roll their closing costs into their loans. Unfortunately, they will also have to pay interest on those loans as long as they have it.
That’s why you need to think about the closing costs and determine whether it applies to your situation. Will you be able to afford to spend thousands of dollars now on the closing costs or are you going to use the money for something else? Should you even consider refinancing even at a higher interest rate? For example, if you’re thinking about rolling the closing costs into the loan, then let’s say $6,000 at 4.5% interest over the course of 30 years is going to cost you an extra $5,000 down the line compared to simply paying the money out of your pocket right now.
A Weak Credit Score
Credit scores play a significant role in finding out the type of refinancing rate that homeowners can qualify for. The higher your score, the better the refinance deal is going to be. If the credit is really weak, it’ll be harder for you to find a lender whom you could work alongside with on a refinance. And even if by chance you somehow manage to get qualified for the loan, the interest rate wouldn’t probably be that impressive.
When the interest rates are low, homeowners are tempted to take anything that the lender offers them. To get a better deal, it would be wise if you wait for your credit score to improve.
When to Refinance a Mortgage: FAQs
When should you not refinance your home?
Consider all of the disadvantages that we’ve covered in the passages above. Some of those reasons include not being able to afford closing costs and not planning on staying long.
How much the lower interest rate is worth refinancing?
Refinancing costs between 2-5% of a loan’s principal.
Is it better to pay extra on a mortgage or refinance?
The extra mortgage payments would reduce the extended life of a loan, which in turn reduces the refinance’s benefit. Then again, if the lower rate of refinancing allows you to get rid of the extra payments, then a longer mortgage term is more viable.
Is it worth refinancing if I save $100 a month?
Basically, the longer it takes homeowners to spend in a house, the more it makes sense to refinance. Otherwise, if you move for a job, it wouldn’t make much sense.