Mortgage refinance is a popular strategy among homeowners because it can lower one of their largest expenses: the mortgage interest rate. But refinancing your mortgage can also be a big investment in time and money. Only refinance your mortgage if the savings justify the effort and expense.
If you’re on the fence about refinancing, answer the following seven questions to find out whether it’s the right time. Pay special attention to questions five and six.
Refinancing your mortgage can be a big investment in time and money. Only refinance if the savings justify the effort and expense.
What are your mortgage refinancing fees?
Approach a mortgage refinance as an investment. To calculate the return on investment of a refinance you need to know how much it will cost you. Ask your lender for a detailed estimate of the fees involved. Check the rates and fees of at least three lenders.
The closing fees of a refinance can cost 1% to 3% of the mortgage balance. On a $250k mortgage, that is $2,000 to $6,000. (Source) You also need to consider the work and time involved. A typical refinance can take months to process.
How much have interest rates dropped, and how much do you owe?
This is key. If the interest rate on your new mortgage isn’t at least 1% lower than your current rate, refinancing is probably not worth your time. That doesn’t mean a 1% drop in rates always justifies a mortgage refinance. A lot depends on how much you owe on your mortgage. A 1% drop in your interest rate means a lot more when you have a $1 million mortgage than when you have a $100k balance.
Sometimes, it makes sense to refinance even if your interest rate stays the same or even rises. For instance, you may want to reduce the risk of interest rate hikes and change your variable-rate mortgage to a fixed-rate mortgage. Or maybe you need cash and you decide to refinance your current mortgage for one with a larger balance and pocket the difference.
SuperMoney makes it easy to compare the rates of the top lenders in the refinance business.
Does your mortgage have a prepayment penalty?
A prepayment penalty is a fee lenders charge borrowers for paying off their mortgages early, which cuts into their profit margins. Yes, prepayment penalties can be a deal breaker for your home loan refinance.
To illustrate, a $200k mortgage with a 4% prepayment penalty will add $8,000 to your closing costs. It would take 72 months to recover those costs on a 30-year 200k mortgage refinance if you reduced your interest rate by 1%.
Will the new mortgage have a shorter term?
If your refinance reduces both your interest rate and the time you take to repay it, your savings could be huge. The trade-off, of course, is that your monthly payments will be higher.
For instance, let’s say you shorten your 30-year $200k mortgage to a 15-year mortgage. You’ll save $43,671 over the life of the loan, assuming you pay $2,000 in closing costs. If you also negotiate a 1% interest rate reduction — let’s say from 3% to 2% — you could save $60,617 over the life of the loan. Just make sure you can afford the higher monthly payments that come with a shorter mortgage term.
On the flip side, lengthening the term of your loan – say from a 15-year to a 30-year mortgage — will almost certainly increase the overall cost of your home loan even if your interest rate drops.
What’s your break-even point?
Your break-even point is the number of months it will take for your refinance to pay for itself and start saving you money. Calculate your break-even by dividing the closing costs of your refinance by your monthly savings.
For example, let’s say you have a $250k mortgage with a 30-year term and you reduce your interest rate from 4% to 3%. Assuming $2,500 in refinancing fees, you will save $27,180 in interest over the life of the loan. However, it will take 23 months before you break even.
How long do you plan to keep the mortgage?
You can easily lose money on a refinance. Mortgage refinancing can reduce your monthly payments, but it typically takes 3 to 5 years to cover the closing costs of the new mortgage. Sell too soon and you could be in the red, as far as your refinance goes.
That’s why you should always calculate your break-even point before even considering a refinance. If you’re planning to sell your home before or close to your break-even point, you probably shouldn’t refinance.
What if your home is upside down?
Refinancing your home when you owe more than it’s worth is not easy. Yet, there are options for underwater homeowners who want to benefit from lower interest rates.
The Home Affordable Refinance, HARP, helps homeowners with negative equity refinance their mortgage. The program, which ends on September 30, 2017, can lower your monthly payment and reduce your mortgage’s interest rate. (Source)
FHA Short Refinances are another option for homeowners with negative equity who are up-to-date with their mortgage payments. (Source)
FHA streamlined refinancing simplifies and reduces the cost of refinancing for people who have a Federal Housing Administration mortgage. The program waives many of the typical lender requirements to process a refinance, such as income and employment verification, credit check, and home appraisal.
Veterans and members of the military can qualify for VA streamline refinancing, which helps veterans get lower interest rates on their mortgage.
The bottom line
Refinancing your home can save you thousands of dollars in interest and help you repay your mortgage earlier. But you need to calculate the cost and take an honest look at your plans for the next few years to determine whether a refinance is a smart investment for your household.
Find out if refinancing is an option by checking the rate and refinance fees of the top mortgage lenders in the business.