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If you’re a homeowner, you know that getting a mortgage for the first time can be really stressful. You’re not quite sure what you’re signing up for. You fear you’re making a terrible mistake.
But after a while, you get used to making your monthly payments and it becomes no big deal.
At some point, if mortgage interest rates decrease, you may start shopping for refinancing options. Or lenders may start reaching out to let you know that interest rates have dropped.
You’re intrigued. But refinancing your home mortgage may feel daunting, and you’re not sure if you’ll benefit. When should you refinance?
Some questions you might be wondering:
- Why should I refinance my mortgage?
- When should I refinance my mortgage?
There are several reasons why refinancing may make a lot of sense for you.
And there are a few things to keep in mind before you choose to refinance.
What Is a Mortgage Refinance?
Refinancing your mortgage means you take out a new loan with a new (lower) interest rate and a new term — the length of time for repayment. This new loan replaces your existing mortgage.
When you refinance, your new lender pays off the original loan, and you start making payments towards the new loan.
There are some fees involved with this process which we’ll cover below.
When Should I Refinance My Mortgage?
The rule of thumb for choosing when you should refinance your mortgage is this:
Refinance when you can save an interest rate of 0.75% or higher.
I’m currently refinancing my mortgage because my original rate was 4.25% and my new rate is 3.25%.
Accounting for closing costs and the amount of money I’ll save in interest, I’ll break even in about 2 years. Since I plan on owning my home for the foreseeable future, refinancing is worth it to me.
Why Should I Refinance My Mortgage?
Since you took out your current loan, your credit score may have improved and interest rates may have gone down enough for refinancing make sense. If your credit is high and mortgage rates have dropped, you may be able to find some great refinancing options.
The main reasons you might consider refinancing your mortgage are:
- Reduce your interest rate (and overall interest payment)
- Reduce your monthly payment
- Pay off your home faster
- Change your loan type (from variable to fixed, for example)
- Change your loan terms (30-year to 15-year)
- Access your home equity
- Reduce mortgage insurance
Reduce Your Overall Interest Payment
Lowering your interest rate is the top reason people refinance. A reduced interest rate leads to an overall reduced interest payment. And that leads to savings.
Refinancing could save you tens of thousands of dollars in interest over the lifetime of your loan. And since those dollars are freed up, you can use them to save and invest which puts your dollars to work for you.
Reduce Your Monthly Mortgage Payment
Reducing your monthly payment is one of the most immediate benefits you get from refinancing your mortgage.
A lower monthly payment gives you options. You can choose to spend a bit more on things that add value to your life. Or you can save and invest more. Or you can make higher payments towards your mortgage principal to pay off your home faster.
Having lower monthly payments and a lower overall interest amount is better for you in the short-term and long-term.
Pay Off Your Home Faster
A lower interest rate or a shorter loan term may help you pay off your home much faster.
With a reduced monthly payment, you can choose to continue paying the same amount you were used to from your previous loan to pay down your loan faster. (Just make sure there are no pre-payment penalties with your new loan.)
Paying off your mortgage faster has the benefit of increasing your home equity faster — the amount of your home that you actually own.
And once your loan is paid off, it frees up the monthly cash you’re currently pumping into your home.
Some people are against paying off your home faster than necessary if the interest rate is low enough to justify investing instead. The reason: an average investment return from those dollars will outperform the savings you’ll realize by paying off your mortgage faster.
Other people may be okay with missing out on potential gains and prefer the mental and emotional peace that comes with being out of mortgage loan debt.
Change Your Loan Type
Mortgage loans come in two types: fixed-rate and variable-rate.
Variable-rate loans may start out with lower interest rates, but the rate can end up increasing after the initial fixed-rate period ends.
A fixed-rate loan, as the name implies, guarantees that your interest rate will not increase at some point in the future.
If you have a high-interest variable-rate loan, you may want to consider getting a lower fixed-rate loan.
Change Your Loan Terms
If you can afford to pay a higher monthly payment, you may want to reduce the loan term (from a 30-year to a 15-year term, for example).
Paying off the loan faster might cost you more monthly, but it can end up saving you tens of thousands in interest over the life of your loan.
Access Your Home Equity
If you’re interested in getting some cash — ideally to make improvements to your home or pay off other outstanding debt — you may want to use what is called a cash-out refinance.
In a cash-out refinance, you take out a new loan for higher than the principal balance on your current loan. You get the difference in cash.
NerdWallet’s article on Cash-Out Refinance Pros and Cons provides great information on how to access your home equity and how to use it to increase your home value.
Reduce Mortgage Insurance
Private mortgage insurance (PMI) is a fee you pay to offset the risk your home loan creates for lenders.
When you take out a mortgage, if your down payment is less than 20% of the home’s value, you pay an amount of PMI that varies depending on your credit score and your loan amount. Once you have 20% equity in your home, you can eliminate your PMI payments.
Bankrate offers a great article on how to get rid of private mortgage insurance.
Things to Consider Before Refinancing
Before you refinance, there are a few things to consider.
- Closing costs and the break-even point
- How long you plan to stay in your home
- Avoid pre-payment penalties
Consider Closing Costs and the Break-even Point
When you refinance, you’ll have closing costs associated with the loan. These costs include a percentage of the loan amount, lawyer fees, title fees, and appraisal fees. You may even have to pay for a termite inspection fee (like I did) which the state of Texas requires.
It’s beneficial to refinance if the interest that you would save as a result of refinancing will repay the closing costs within a couple of years and you plan to stay in the home past that point.
Imagine you have a current interest rate of 4.25%, and you have the opportunity to take out a new loan for 3.25%. This would save you 1%. If your loan amount is $200,000, then 1% of your loan is $2,000. If the closing costs are $4,000, it would take you 2 years to hit your break-even point.
Using the example above, in the first two years, you’re in the red. But after 2 years, you’re effectively saving money from the deal.
You can estimate your break-even point, but you’ll have to get specific numbers from a lender before you know exactly what it will be. Every lender I talked to gave me an estimate during our initial conversation and more precise numbers after I provided more information.
Consider How Long You Plan to Stay in Your Home
If you’re going to maintain ownership of your home for less than the break-even period, it isn’t worth refinancing. But if you’re going to stay in your home for years past the break-even point, it probably makes financial sense to refi.
Avoid Pre-Payment Penalties
While loans rarely have pre-payment penalties, just make sure you won’t be charged for making early payments.
There’s no reason to take out a loan that has pre-payment penalties. Whether or not you’re currently interested in paying off your mortgage faster, you want to have the option to pay whatever amount you want towards your mortgage.
The Bottom Line
When should I refinance my mortgage? It depends.
If you can get a lower interest rate that saves you at least 0.75% on your existing loan, it’s probably worth considering a mortgage refi.
Some reasons you may benefit from refinancing include:
- A lower interest rate which leads to overall lower interest payments over the lifetime of your loan.
- Reduced monthly payments, so you can choose how to spend the amount you free up.
- Changing your loan type (like from variable to fixed) or changing your loan terms (like reducing a 30-year mortgage to a 15-year loan).
- Paying off your home faster and increasing your equity
- Accessing your home equity — which is best used to improve your home or reduce other debt
- Reduce your private mortgage insurance by increasing the amount of equity you have in your home
Just be sure to consider closing costs and the break-even period to make sure refinancing makes sense for your situation.