A few years after making monthly mortgage payments, many homeowners start wondering whether they should refinance. Refinancing a mortgage can sometimes save you a lot of money, but it's not always your best move.
What is refinancing?
First, let's review just what refinancing is. Remember how you got a mortgage when you bought your home? Well, when you refinance, you essentially trade in your current mortgage for a newer one -- ideally one with more attractive terms. The new loan pays off the first one.
The main reason most folks refinance a mortgage is to take advantage of a lower interest rate and thereby end up with smaller monthly payments. But that's not the only possible reason. You might refinance a 30-year loan into a 15-year one, ending up with larger payments, but fewer of them, and less total interest to pay.
When refinancing is smart
Here are circumstances in which refinancing can make good sense:
- You want to have smaller monthly payments by reducing your mortgage's interest rate. Ideally, you'll have a good credit rating or credit score, because the better your credit profile is, the better interest rates you'll be offered. About 90% of lenders will check your FICO credit score, and the folks at MyFICO.com have a handy interactive table showing you what a difference your credit score makes in the interest rates you're offered. When I checked it recently, it showed that if you were borrowing $200,000 via a 30-year fixed-rate mortgage, and you had a top FICO score, in the 760 to 850 range, you might get an interest rate of 3.782%, with a monthly payment of $930 and total interest paid over the 30 years of $134,752. If your score was 650, though, your rate would be more like 4.825%, with a monthly payment of $1,052 and total interest of $178,848. That's $122 more per month ($1,464 per year) and a whopping $44,000 more in interest.
- You want to shorten the life of your loan. If you took out a 30-year mortgage and are 15 years away from retirement with 22 years left on your loan, you might not relish the thought of having to make monthly mortgage payments while on a limited and fixed income. Many people aim to own their home with no mortgage by retirement, and a short-term loan can help you achieve that, despite monthly payments that can be steeper.
- You want to change the terms of your loan. You might have taken out an adjustable-rate mortgage that had an ultra-low rate that stayed in effect for five years. Well, if those five years are up and interest rates seem to be rising, you might not want to face rising mortgage payments in future years. So you might refinance to a fixed-rate mortgage, ending up with payments that might be higher than what you face now but that won't rise anymore.
When refinancing is not your best move
It's not always great to refinance. Here are some considerations to keep in mind:
- If you don't think you'll stay in your home long enough to recoup the closing costs for the refinancing (yes, there are closing costs -- the process is very much like getting your initial mortgage), then don't refinance. If your closing costs are $2,500 and you'll be enjoying monthly payments that are $100 lower, then it will take you 25 months to break even so that the refinancing was worth it.
- If you won't be able to reduce your loan's interest rate by about one percentage point, going through the trouble of refinancing may not be worth it. Online calculators can help you crunch the numbers to decide.
- If you're refinancing to take out some of your home equity, think twice. You'll often end up with a bigger loan balance than you had before refinancing, and less equity in your home, too. In exchange for that, you did receive a chunk of change, but if you used it to remodel a kitchen or buy a new car, you probably won't come out ahead, financially. The car will start depreciating immediately, and most remodelings don't net you more when you sell the home as you paid for them. Only cash out if you really need the money. Every dollar you borrow with your mortgage will probably take a long time to get paid off, costing a lot in interest.
- If you're refinancing to lower your payments by lengthening the life of your loan (perhaps by going from a 15-year loan to a 30-year one), be sure that you're OK with paying thousands more in interest and being in debt much longer. You might mitigate the downside of this move by enjoying lower payments but making a few extra ones throughout the year, which can reduce the life of your loan and save a lot in interest. Just be sure that your new loan permits prepayments.
- If you're refinancing to consolidate debt, perhaps because you'd like to pay off high-interest-rate credit card debt with low-interest mortgage debt, think twice. It can be an effective strategy, but if you're saddled with credit card debt because you tend to spend beyond your means, then you're not likely to suddenly change your ways. You'll instead be taking on more long-term debt, while feeling unburdened by credit card debt and perhaps feeling freer to spend beyond your means again.
There are many considerations when you're thinking about refinancing a mortgage. Think through them all, and you can save a lot of money.