When and How to Refinance

When and How to Refinance

Whether you’ve been a homeowner for a few years or more than a decade, you may consider refinancing your home loan whenmortgage rates dip. If you’ve never refinanced before, there are a few basic facts you need to know before you can decide if it’s right for you.

Refinancing basics

You may be thinking since you’ve faithfully made all your mortgage payments on time and your income has even increased a bit since you applied for the loan, refinancing should be a breeze.

But when you’re refinancing, you’re applying for a new loan. And whether you use the same lender or another lender, you’ll be subject to complete documentation and verification of your income, your assets, your debt-to-income ratio, your credit profile and your job history. Not only do you have to qualify for the loan, but your house must appraise for enough value to support the loan.

Refinancing also costs money: closing costs vary by location but average 2% to 3%, or $4,000 to $6,000 on a $200,000 loan. Even a “no-cost” refinance costs money you pay through a higher interest rate, a larger loan balance or the payment of discount points.

If you’re refinancing to lower your payments, you can do a simple calculation to determine how long it will take you to recoup the closing costs on your loan. For example, if your refinance costs $2000 and your monthly savings are $150 per month, it will take you a little over 13 months before you’ve recouped your costs and truly are saving money.

Refinancing goals

Your decision to refinance or not should be made in the context of your overall financial plan. Most people want to refinance when interest rates are low, so they can pay less in interest and lower their monthly payments. Some borrowers also want to refinance an adjustable rate mortgage (ARM) into a fixed-rate loan before rates rise faster.

Others refinance when their equity has risen and they want to take cash out of the property to make home improvements or pay off high-interest credit card debt.

Refinancing can also be a good choice if you want to reduce your loan term from a 30-year loan to a 10-, 15- or 20-year loan in order to pay it off in full faster—although even with lower rates, your payments are likely to be higher because of the shorter timeframe to repay the loan.

Loan terms and refinancing

If you’re currently financing your home purchase with a 30-year, fixed-rate loan, you should carefully evaluate your payments and your options for refinancing into a shorter term or into another 30-year loan. Typically, it doesn’t make a lot of sense to refinance early in your loan, because initially your payments are mostly interest—and you won’t have paid down the principal balance.

If you’ve been paying your loan for seven or eight years, your loan balance will be lower. If your goal is to lower your monthly payments, you’ll benefit by both lower mortgage rates and financing a smaller amount of money. However, by extending the loan term for another 30 years, you may end up paying more in interest over the life of the loan, since you’re essentially paying interest on the house for 37 or 38 years instead of the original 30-year term.

If you want to pay off your loan faster, you should compare the payments on a shorter term loan to see if you can comfortably afford the payments. Interest rates are lower on shorter term loans, which can offset the accelerated payoff pace.

Refinancing and future plans

Refinancing makes the most sense if you plan to stay in your home for a few years, because if you’re selling soon, you may not recoup the cost of the refinance. However, there are always exceptions to the rule, so if you know you’ll sell in three years, for example, a refinance into an ARM with a low, fixed interest rate for five years could be a smart decision.

Always make sure to consult a lender to discuss refinancing in the context of your individual financial plan.