How to Tell When You Should Refinance Your Mortgage

Thinking about refinancing your mortgage? Make sure you ask yourself these important questions before moving forward.One of the biggest decisions homeowners face is how to tell when it’s time to refinance their mortgage. It can be so enticing when there are advertisements everywhere promising lower interest rates and cheaper mortgage payments, but refinancing isn’t always the right answer for everyone.

You may have heard the oft-quoted, general rule of thumb to refinance when interest rates go down a full point, but it’s not exactly that simple.

Just like buying a new house, refinancing a mortgage isn’t a decision to make lightly – you need to do your homework first.

Every borrower has a different situation and a different budget, and just because rates have dropped by a full point or more doesn’t necessarily mean it makes sense for you to refinance.

So when should you refinance your mortgage? We’re going to take you through the factors you need to consider, and the questions you need to ask yourself, so you can make an informed decision.

What Are Your Plans?

The first question you need to ask is what are your plans with your home? Do you plan on living in it another 3 years? 10 years? Forever?

It’s an important factor in deciding whether or not to refinance, because if you aren’t planning on remaining in your home for many more years, it likely doesn’t make sense to refinance.

While you can’t predict the future, try to consider where you’ll be a few years down the line. If you currently own a one bedroom condo, but plan on having kids and moving into a house (complete with a backyard and the extra square footage that kids typically require), you may want to think twice before you refinance.

Consider your future plans and goals before you tack on a few thousand dollars in extra closing costs just to save a few dollars a month right now.

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Why Do You Want to Refinance?

There are many different scenarios as to why you might opt to refinance:

Make sure you have a good reason for refinancing before signing those loan papers. Many borrowers opt to lengthen their term (say from 15 years to 30 years) simply to get a smaller payment.

Other borrowers take the opposite route and shorten their mortgage broker term, which results in a higher payment, but a faster route to a mortgage-free life.

If your goal is to shorten your term to pay off your home faster, or to keep your same term but get a lower interest rate, in some cases it might make more sense to keep your current mortgage and simply pay extra on the principal.

What Kind of Mortgage Do You Currently Have?

Do you have a fixed rate mortgage? An ARM? Balloon? The kind of mortgage you have will influence whether or not refinancing is a good idea.

If you currently hold a fixed rate mortgage, and you bought your home in recent years when rates were historically low, and you’re in your “forever home”, it’s in your best interest to consider if refinancing will save you money in the long run.

If your mortgage is currently on an adjustable rate or balloon note, you should absolutely check to see if refinancing makes sense for you. In many cases (balloon notes), you may be required to refinance.

Also check to see if your mortgage note has a prepayment penalty, which will require you to pay a percentage of your mortgage just to get out of it, because that could be a deal breaker.

Weigh Your Options

If your goal is to get a better rate to pay your house off faster, see if you can pay extra towards your principal instead, especially if interest rates are only a point or two lower than what you currently have.

Going with this option makes sense when you don’t have many years left on the term of your mortgage. It can also make sense if you simply want a shorter term.

If interest rates aren’t that different from what you already have, consider if it makes more sense to pay extra to principal rather than refinance.

If you have some wiggle room in your current budget and think you can afford to pay a little extra each month, you can rack up some big savings on your current mortgage without tacking on extra closing costs with a refinance.

Remember that for every extra dollar you can pay on your principal loan amount, you’ll save on interest over the term of your loan.

The Downside of Refinancing

Refinancing isn’t just an easy way out of a higher cost mortgage. Each time you get a new mortgage, whether it’s through a new purchase or a refinance, you’re adding on additional closing costs to your loan amount.

For example, if you currently owe $100,000 on your mortgage and you want to roll in your closing costs when you refinance, you could end up with a new loan amount of $103,000.

It’s important to realize that these additional fees are substantial, so don’t jump into refinancing just because you can roll them into the loan amount instead of paying them out of pocket now.

The additional closing costs will affect you in the long run, because you’ll eventually pay for them when your mortgage is paid off, or when you sell your home.

It’s important to consider how long it will take you to recoup those fees in terms of monthly savings, otherwise known as your break even point, assuming you get a better interest rate or lower payment.

When Is the Break Even Point?

If you refinance, how long will it take to recoup your closing costs and get to the break even point? With simple math, you can easily determine your break even point with a new mortgage payment versus your old one.

For example, let’s assume that your old mortgage payment is $1,000 and your new mortgage payment is $900 (with your mortgage amount still being $100,000).

You’re saving $100 per month, but rolled your $3,000 closing costs into your new loan, resulting in a new loan amount of $103,000, or $3,000 more than your original loan amount.

It’ll take 30 months, or 2.5 years, to break even with your refinance. That refinance won’t pay for itself for 2.5 years, and if you sell your home before that time period is up, then you’ve actually lost money.

Don’t cost yourself money by refinancing without a plan. Make sure to weigh the additional closing costs versus monthly savings before refinancing.

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Can You Refinance?

Before you apply for a refinance, you need to consider if you’ll even qualify for a new mortgage.

Have you maintained steady employment and showed that you can pay your bills on time? Is your credit score up to snuff? Will your home pass an appraisal inspection?

Just because you already have a mortgage on your home doesn’t automatically mean you will qualify for a refinance. Banks are still picky about everything from the condition of your property to your credit and income history.

The two main factors that affect the interest rate you qualify for are your credit score and the loan-to-value of your home, so make sure your credit score is in good shape so that you qualify for the best rates available.

Will Your Home Appraise?

Make sure to have a general idea of the value of your home before you try to refinance – don’t guess what your home is worth. Do a little research and check to see what comparable homes in your area have been selling for in the past 6 months. The homes you compare need to be similar in size, condition, style, and acreage to your home to be considered as viable comparables.

Many people go into the refinance process without having this information, and that can lead to an unsettling surprise if your home is valued by an appraiser at tens of thousands of dollars less than you expected – and at a value that won’t allow you to refinance.

It’s not worth it to waste $300-$500 on an appraisal only to find out that you can’t refinance due to the unexpected value of your home. With a little research up front, you can avoid this frustration.

When the appraiser does visit, provide a list of improvements you’ve made to the property, but don’t be surprised if you don’t get the added value you expected (i.e. for that finished basement or your new tiled floors). Be there when the appraiser is doing the inspection, and make sure to provide him with any information he needs.

Hopefully you won’t need to make any repairs to your home, but if there is a glaring improvement that needs to be done (i.e. flooring that needs to be finished or a hole in the roof), go ahead and make those repairs before the appraiser comes to visit. It’ll save you money in the long run as you won’t have to shell out money to an appraiser twice.

Loan-to-Value Ratio

Once the appraised value of your home is determined, you’ll be able to determine your loan-to-value ratio (LTV). The LTV of your home is the percentage of the appraised value that you want to borrow on your home, and this percentage affects the interest rate you’re eligible for, and determines whether or not your new loan will require mortgage insurance (MI).

If your LTV is over 80%, mortgage insurance will be required, which is an additional charge to consider, especially if you don’t currently pay MI and are using a cash-out refinance to pay off other debt.

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There are a lot of important factors to consider when refinancing, and if you still aren’t sure whether it’s the right time to refinance, ask for recommendations from friends or family for a good mortgage broker. They can help you look at your situation to determine if it’s a wise time to refinance or not.