5 Essential Questions to Answer Before You Refinance Your Mortgage

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Low rates aren't the only factor when you consider a mortgage refinance.

Historically low mortgage interest rates are still available. Since even a modest decrease in interest rate can save you a significant amount of money over the life of your mortgage, it makes sense to contemplate a refinance. Here are five questions to ask yourself before you refinance your current mortgage.

1. What rate makes sense for you?

Mortgage interest rates have been low for a while. If you already have a low rate, a small decrease in the interest rate might not be significant enough to recover the cost of refinancing. A difference of about 1% could be enough to make a refi a good idea. Less than 1% may not be enough to make it worthwhile.

How do you know what rate you'll get? You'll need to apply. Mortgage lenders look at:

  • Your credit score
  • The loan-to-value ratio (how much you want to borrow compared to the appraised value of the home)
  • Your debt-to-income ratio (how much of your pre-tax income goes to debt payments each month)
  • Your liquidity (how much cash you have)

Rate shopping is a great idea. Apply with at least two or three lenders so you can compare offers. Try to apply on the same day because rates change frequently. Also, make all of your applications within a two-week period or your credit score might suffer. Normally, every time a lender checks your credit, your score can drop a little. But all mortgage inquiries are counted as one if you make your applications within 14-45 days (different credit scores have different rate-shopping windows).

2. When will you reach the break-even point?

The break-even point is the date when the money you have saved equals the money you had to spend to get the new loan.

To figure out yours, you'll need to know your closing costs. For example, to get the lowest rate, you'll probably have to pay for points. Points are prepaid interest, a fee you can pay in exchange for a lower rate that will apply for the life of the loan.

Other closing costs might include:

  • Origination fee
  • Underwriting fee
  • Appraisal fee
  • Recording fees and taxes
  • Credit report fee
  • Flood determination fee
  • Title insurance
  • Title search fee

Your closing costs will be listed on the loan estimate you receive from the lender after you apply, so be sure to give it a close look.

Once you know your closing costs, you can figure out how long it will take to recover it. Here's an example:

Current monthly mortgage payment $1,000
Closing costs $3,500
New monthly mortgage payment $900
Monthly savings $100
Number of months to recover closing costs 35

In this example, the borrower's break-even point is in 35 months ($100x35= $3,500). If the borrower plans to sell the home sooner, refinancing won't save them money (even with the lower payment).

3. What loan term makes the most sense for you?

If you are several years into your mortgage, you might prefer to get out of debt sooner rather than later. A new 30-year loan might not be the best option.

Many lenders will let you choose the exact number of years you want the new loan term to be. For example, if you have 21 years remaining on your original mortgage, you can choose a 21-year term on the refi. Even if the lender requires you to choose from 10, 15, 20, 25, or 30 years, you can pick one that gives you the best balance between an affordable monthly payment and an end in sight.

Use a mortgage calculator to look at payment amounts and the total cost over the life of the loan when you compare terms. A lower payment can give your budget some relief right now, but if the loan term is longer, you'll pay more in interest. Plus, a shorter term often comes with an even lower interest rate.

As an example, here are some ways you could structure a $200,000 loan at 3.25%:

Monthly payment Loan term Total cost
$871 30 years $ 312,480
$1,135 20 years $ 271,719
$1,406 15 years $ 252,576

4. How much time do you have before your next ARM adjustment?

With an adjustable-rate mortgage, your interest rate periodically changes. It can go up or down, depending on the benchmark rate it's tied to. If interest rates rise, your mortgage interest rate goes up. With a fixed-rate mortgage, your interest rate stays the same for the life of the loan.

Refinancing an adjustable-rate mortgage to a fixed-rate mortgage can be a good idea. It depends on where you are in your current loan and what your plans are.

First, if you plan to sell within a few years, check the break-even point carefully. The cost of a refi could be on par with the cost of an expected increase in your rate.

Next, consider how often your rate adjusts and how close you are to the next adjustment. If you have some time before your next adjustment, now might not be the right time to refinance. Instead, you can take your time and explore options.

5. Is a cash-out refi a good idea?

A cash-out refinance is when you borrow more than the amount you owe on your home, and you get the difference in cash. You need equity to do this. Equity is the difference between what you owe on your home and what it's worth.

One of the best reasons to borrow against the equity in your home is to pay for expenses that will improve the property. Here are some reasons many people take cash out:

  • Home improvements
  • Necessary maintenance
  • To buy more property

On the other hand, some reasons to get a cash-out refinance need a little more consideration before you commit:

  • Education: You probably don't want to go into debt for someone else's education. And weigh the pros and cons of going into debt for your own education -- including whether you expect it will help you earn more.
  • Investing: Borrowing money to invest is always risky. No one who loses money planned to.
  • Financing a business: Decide if you are comfortable putting your home on the line for your business. Many entrepreneurs are, but consider the risks.
  • Emergency expenses: You might not have any other choice, but check your options carefully. For example, a hospital can't take your home to cover medical bills.

And for these situations, you might want to research other options:

  • Vacation: Consider adding some extra cash to your savings account instead of borrowing. There's a real sense of satisfaction that comes from enjoying something you've worked hard to save up for.
  • Wedding: If you don't want to start your new life together with a new debt, this could be a good reason to boost your savings too -- instead of getting that loan.
  • Consolidating credit card debt: You might save on interest with a refinance, but if you run into financial trouble in the future, you could lose your home. Consider a balance transfer card if your credit card debt is getting higher than you'd like.

Is now the right time to refi?

Even if you've heard that rates are going up, don't rush into a new loan. Run the numbers and consider your motivations. A mortgage refinance can be a great idea, but it pays to figure out the best scenario for your finances before you take the plunge.

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