Refinancing a Home: Why or Why Not?

Credit: Frank Kovalcheck via Flickr.

When interest rates drop, there's often a surge in home refinancing. A low-interest-rate environment is bad for savers, but it can be great for those interested in refinancing a home -- or buying one. The good news is that interest rates are still at low levels.

If you're interested in refinancing a home, here are some tips and some things to consider.

Why you might want to refinance a home
First off, why should you consider refinancing a home? The obvious reason is that you can save money by securing a mortgage with a lower interest rate. Given the sums of typical mortgages, the overall savings can amount to tens of thousands of dollars, or even more. Remember, though, that refinancing a home involves getting a new mortgage to replace your existing one, and the interest rate is just one variable.

You can also change the terms of a loan -- for example, turning a 30-year loan into a 15-year loan, or vice versa. A shorter loan life might demand higher monthly payments, but you'll build equity and own your home sooner -- and you'll pay a lot less in interest. And if there's enough of a difference in interest rates, you might snag lower monthly payments and a shorter term! (Meanwhile, if money is tight, you might want to stick with or switch to a 30-year loan.)

Refinancing a home can also mean switching from an adjustable-rate mortgage, or ARM, to a fixed-rate mortgage, or vice versa. An ARM can offer lower monthly payments, but if rates rise, so will those payments. Rates look like they will remain low in the near future, but they're so low now that eventual increases are likely. Locking in prevailing low rates can be smart.

Debt consolidation is another possibility with refinancing, as you can combine your existing mortgage with a home equity loan in a single new loan.

Why you might not want to refinance your home
Refinancing a home is not always your best move, though. For instance, a rule of thumb is to only refinance if the prevailing rates are lower than your existing mortgage rate by 1 percentage point or more. Still, even that isn't enough. Think about how long you expect to be in the home. If you plan to sell it and move within a few years, you probably won't make up for the cost of the refinancing, as there are closing costs to factor in. You can do the math this way: If the total cost of refinancing amounts to $3,600 and you're going to save $200 per month in payments, then your breakeven point is 18 months.

If you're only interested in refinancing a home in order to cash out some of your home equity, think twice. Yes, you can use that money for something that seems important, but you're also reducing your net worth. Make sure you do so for something truly important, such as college costs or paying off high-interest debt. Refinancing does allow you to consolidate your debt and convert high-interest debt into low-interest debt, but if you're the type to run up more debt on your credit cards, refinancing won't be of much help.

Banks are being pickier about who they lend to these days, so you might not qualify for the best, lowest interest rates. In general, you'll need a credit score in the 700s in order to get a low rate. Refinancing also takes time and energy as you shop around for the best deal and manage a lot of paperwork.

You may also not want to refinance if you've held your current mortgage for a long time. In that case, your monthly payments, which started out as mostly going toward interest, are now mostly going toward your principal. By refinancing, you start the amortization process all over again, and your new payments will again mostly go toward interest.

Finally, check whether the mortgage you want to refinance has a prepayment penalty. If it does, factor that into your thinking about refinancing a home. And if you do refinance, consider making sure that doesn't entail a prepayment penalty.

Before you begin refinancing a home, learn more about it -- and crunch some numbers, too, to see if it makes sense. We have some online calculators that can help, as do other sites. The National Bureau of Economic Research, for example, offers a calculator to help you decide whether refinancing a home is worth the trouble.

Another way to save big bucks
Refinancing isn't your only path to saving more and spending less. Consider paying less in taxes, too. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about a simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.

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Selena Maranjian

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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