When you take out a mortgage, you're not just required to pay back the principal amount on that loan; you're also on the hook for interest payments, the amount of which are a function of the rate you snag. If you're struggling to keep up with your mortgage payments, or simply want to lower them, then it could make sense to refinance your home loan. Here's how to know if that's the right move for you.
What is refinancing?
The term refinancing doesn’t only apply to mortgages; it applies to various types of debt, like student loans and even credit cards. When you refinance, you effectively swap an existing loan out for a new one. In the case of a mortgage, your new lender pays off your previous home loan, and then you start making payments on your new loan.
Is refinancing right for you?
Refinancing generally only makes sense if you're able to snag a lower interest rate on your mortgage in the process. Otherwise, what's the point of going that route? But even if you do manage to lower your interest rate, there are other factors to consider.
Just as you pay closing costs when you take out an initial mortgage, so too are you liable for closing costs when you refinance. And in some cases, those costs can be substantial. As such, you'll need to make sure the savings you reap by lowering your monthly mortgage payments are enough to justify the cost of refinancing.
As a rule of thumb, you shouldn't refinance your mortgage unless you're able to reduce your current interest rate by at least 1%. But, you'll also need to make sure you're planning to live in your home long enough to recoup the money you spend on closing costs and come out ahead on your monthly payments. If you're planning to move in a year or two, refinancing may not make sense.
For example, imagine that by refinancing, you're able to shave $150 a month off of your current mortgage payment. That's some nice savings. But if you spend $3,600 in closing costs in the course of refinancing, it'll take you two years to break even -- so if you're not planning to stay in your property that long, it's not worth it.
Another thing to consider is that when you refinance your mortgage, you often wind up resetting the clock on that loan. Imagine you take out a 30-year mortgage at age 35, and then refinance five years later to another 30-year mortgage. At that point, you're looking at paying off that debt at age 70 rather than 65. And that could be problematic if your goal is to pay off your mortgage before retirement.
One strategy you might employ is to refinance to a lower interest rate, but then pay the amount you save each month into your mortgage's principal. In doing so, you'll shorten your new repayment period, thereby compensating for the fact that you're resetting the clock on that loan.
Finally, it doesn't pay to refinance your mortgage if your credit isn't much better than it was when you first applied for your home loan. You're unlikely to snag a much lower rate if your credit score hasn't budged, unless rates have dropped significantly across the board.
That said, if your credit has improved since you took out your mortgage, and you're able to lower your interest rate substantially, then refinancing your home loan could make sense, especially if you're planning to keep that property for a number of years after the fact (or, better yet, indefinitely).
If you are going to refinance, be sure to shop around for the best rate. That way, you’ll be better positioned to recoup your closing costs sooner, and come out ahead.