Should You Refinance Your Mortgage?
Find out if doing a refinance is best for your situation.
This week I’ll be answering a reader’s question about how to know if you should refinance your mortgage:Â
“Hi, Money Girl. I have a quick question about taking a home mortgage. If I were interested in getting a lower interest rate on my home by refinancing my mortgage, but I still plan on moving out of my home in about two or three years, does it actually make sense to refinance? What types of things would I want to actually consider before taking the plunge and refinancing? Anyways, thank you and my name is Ben.”Â
Ben, I appreciate your excellent question! It’s a perfect time to talk about refinancing because right now interest rates are low.Â
What are Interest Rates?
An interest rate is simply the cost of money. Rates in the U.S. fluctuate according to the monetary policy of the Federal Reserve, which is our central bank. When interest rates are low, money’s on sale–as strange as that sounds! Banks should display a big banner on their front door or website that reads “bargain basement prices on dollars” or “we sell money cheap” because that’s exactly what happens when interest rates go down. Low rates are great for borrowers, but not so good for lenders.Â
Low Rates are Good for BorrowersÂ
Back in post 150, I discussed how low interest rates put a squeeze on your savings and I gave tips on where to find the highest rates. When you put your money in a savings account, money market deposit account, or a CD, you’re the lender. You don’t earn much on the money you sock away in the bank when interest rates are low. However, when the tables are turned and you’re the borrower, low rates are great!Â
The Freddie Mac website shows historical data for interest rates on 30-year mortgages since 1971. I’ll include a link to that information at the bottom of this article. In October of 2009 the average for a fixed-rate, 30-year mortgage was 4.98%. A year earlier, the same loan was 6.2%, and ten years earlier it was 7.85%.Â
What is a Mortgage Refinance?Â
If you already have a mortgage, you had to borrow money at the prevailing interest rate at the time you took out the loan. Other factors influenced the rate you were offered, too, such as your credit score and the amount of your down payment.
But the going interest rate is always the most important factor for a mortgage. So when interest rates drop, it’s a good idea to investigate doing a refinance. Whenever rates drop at least one percentage point below the rate you have, take a hard look at refinancing. Before I answer Ben’s question about what needs to be considered before jumping feet first into a refinance, let me make sure you understand what happens when you do one.Â
Refinancing is when you apply for a new loan in order to pay off an existing loan balance. The new loan could be with your same institution or with a different lender. You basically swap out a higher-interest loan for a lower-interest one, which decreases the amount of interest you have to pay. That sounds easy enough, but of course, there’s a cost to doing a refinance. It seems like it takes a village to close a loan and everyone gets their cut. Fees go to the lender or mortgage broker, the property appraiser, the closing agent or attorney, the surveyor, the local government, and maybe more people, depending on where you live.Â
Each lender has different requirements for doing a refinance. Most will require that you have a certain percentage of equity in your property. Equity is the difference between what your home is worth and what you owe on it. For example, if your home is valued at $200,000 and you have a $150,000 mortgage, you have $50,000 in equity, which is 25% of the value.Â
Should You Refinance Your Mortgage?Â
Just because you qualify for a refinance doesn’t necessarily mean that it’s right for you. Refinancing a loan can be expensive. The total cost will depend on the lender as well as the location of the property and could be as high as 3% to 5% of the outstanding loan balance. The trick is to understand what a refinance will cost and how long it’ll take to break even on those costs. In other words, when do you move from being in the red to being in the black on the deal? If you pay for a refinance, but don’t keep the home long enough to cover the costs, you’ll lose money. But if you do keep the property beyond the financial break-even point (BEP), you’ll feel like a genius because you’ll save money in the long run!Â
You may be able to roll closing costs for a refinance into the new loan, which means you would have nothing or little to pay out-of-pocket. But doing that increases the amount you have to borrow and may also increase the interest rate you have to pay for the life of the loan. For that reason, it’s important to ask the lender for a side-by-side comparison of all the terms for each loan option so you can carefully evaluate them.Â
How to Figure a Refinance Break-Even PointÂ
So how do you figure the financial break-even point? It can be a little complicated, but don’t worry, I’ll give you a great online tool that’ll make it a breeze. The break-even point depends on various factors, including:
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the interest rates on the old and new loan,
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total closing costs,
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your income tax rate,
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how long you plan to own the property, and
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any loan prepayment penalties you may have to pay.Â
Ben, my recommendation is to use the refinance break-even calculator at dinkytown.com to help determine if refinancing makes sense for your situation.Â
That calculator can help you cut through the confusion of making an important financial decision such as doing a refinance, but remember that it’s not perfect. For instance, it doesn’t know if you’ll take advantage of the home mortgage interest deduction, which would decrease your taxes and after-tax interest rate you really pay for a mortgage. For more information about how the home mortgage interest deduction works, be sure to refer back to post number 141. But using a refinance calculator will show you how long you’d need to keep the property to recapture all your upfront closing costs, which is usually what most people want to know.Â
What are Other Reasons to Refinance?
The goal of doing a refinance is generally to save money on monthly loan payments by getting a lower interest rate. However, there are other reasons to refinance. For instance, you might want to convert an adjustable-rate loan into a fixed-rate loan. That would lock in a low rate if you believe interest rates are going to rise. Or you might want to cash out equity that you’ve built up in a property to pay for something like a remodeling project or the cost of education for you or a child. Whatever your reason for doing a refinance, be sure to carefully weigh all the costs against the savings you expect to receive.
If you have an underwater mortgage (your home value is below the normal loan to value underwriting guidelines) and would like to refinance, check out my Quick Tip on how to go about it.
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I’m glad you’re reading. Chi-Ching, that’s all for now, courtesy of Money Girl, your guide to a richer life.
More Resources:
Refinance Breakeven Calculator
Mortgage image courtesy of Shutterstock
About the Author
Laura Adams received an MBA from the University of Florida. She’s an award-winning personal finance author, speaker, and consumer advocate who is a frequent, trusted source for the national media. Money-Smart Solopreneur: A Personal Finance System for Freelancers, Entrepreneurs, and Side-Hustlers is her newest title. Laura’s previous book, Debt-Free Blueprint: How to Get Out of Debt and Build a Financial Life You Love, was an Amazon #1 New Release. Do you have a money question? Call the Money Girl listener line at 302-364-0308. Your question could be featured on the show.
