Should I Refinance My Mortgage?

Why refinance?

Your financial situation, and economic conditions, can change a lot in 15 or 30 years. Your monthly budget may get squeezed by other major expenses, you may want to take cash out for a home renovation or you may find you can pay your home loan off more quickly if your income rises. Interest rates may also change, affecting how much it costs to borrow money.

With all of these potential changes, it’s very possible that the mortgage you took out when you first bought your home may not necessarily remain the best solution for your current needs.

Thankfully, you have the option to refinance your mortgage. Refinancing could allow you to lower your monthly payment, pay down the loan more quickly, take cash out, or switch to a different type of mortgage entirely.

What is refinancing?

When you refinance your mortgage, you take out a new loan to pay off your old one. From then on, you make payments on the new loan.

You can refinance multiple times over the life of your mortgage. However, some lenders prefer people wait at least a few months after a refinance to go through the process again. (Closing costs are significant – you would not want to refinance again only months later.)

Read the terms of your mortgage closely. If your current mortgage charges a penalty for early repayment, refinancing (which pays your loan off early) will trigger that penalty.

Why would I refinance my mortgage?

To lower the interest rate. This could mean lower monthly payments and a lower amount of interest paid over the entire mortgage term.

To shorten the mortgage’s term. Shaving even a few years off of your mortgage can save thousands in total interest costs and allow you to build equity more quickly. However, a shorter term could mean higher monthly payments.

To lower the monthly payments. If your budget can no longer sustain your current mortgage payments, lengthening the term can lower what you pay each month. The downside is you’ll pay more in interest over the entire term.

To switch to a different mortgage type. Homeowners can refinance to switch from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, or vice versa. Some home buyers, for example, opt for an ARM with the plan to refinance to a fixed-rate mortgage before the rate adjusts for the first time.

To take cash out. Refinancing provides the option to take some of the equity that has been built up in your home out as cash. This option is often used in place of getting a Home Equity Line of Credit. It would increase the amount of your mortgage balance and could increase the monthly payment depending on the change in rates.

How much does refinancing cost?

Refinancing isn’t free. It typically costs 2 to 3 percent of the amount you’re borrowing. You’ll need to repay closing costs, which vary depending on the size of your mortgage, the lender, and where you live.

Closing costs include a variety of fees: the mortgage application, property appraisal, loan origination, title insurance, and more. The average closing cost for refinancing is more than $4,000.

When is refinancing a good idea?

If interest rates have decreased. You stand to save on monthly payments and the total cost of interest if you can lower the interest rate on your mortgage.

Here’s an example:
You have 25 years left on your mortgage and still owe $100,000 at a fixed 5 percent interest rate. You have the option to refinance to a 25-year, $100,000 mortgage at a 4 percent interest rate. Assuming a $3,000 closing cost (3 percent of what you’re borrowing), you’ll lower your monthly payments by $41 and spend $12,275 less in interest over the life of the loan.

If there’s a change in your finances. You may qualify for more favorable loan terms (like a lower interest rate) if your credit score and debt-to-income ratio have improved.

You may also choose to refinance if your financial situation has become more challenging and you need to lower your monthly payments in order to continue to afford your home. If you lengthen the mortgage’s terms to achieve this, you may pay more in interest.

If you plan to stay in your home for a long time. The monthly savings you can get by refinancing may not be worth it if you don’t live in the home long enough to offset the closing costs.

Consider the previous example of the new $100,000 mortgage at 4 percent. That $41 monthly savings is tempting, but it will take six years for it to offset the $3,000 in closing costs. If you intend to sell your home in less than six years, refinancing may not be a good deal.

If applicable, you can eliminate Private Mortgage Insurance (PMI) payments. If you have an FHA loan, you’re required to pay PMI for the entire loan duration. One way to get around this is to refinance to a conventional loan once you have 20% equity in the home.

When is refinancing a bad idea?

Interest rates have increased. If you’d like to refinance to a mortgage with the same term as your old one, refinancing will end up costing you more, both in monthly payments and total interest paid.

However, there is a way to save money by refinancing if interest rates have gone up. If you plan to refinance to a mortgage with a shorter term, it’s possible to save on total interest paid.

Let’s say you have 25 years and $100,000 left on your current mortgage, which charges 4 percent interest. If you refinanced to a 15-year mortgage with a 5 percent interest rate, you’d pay $287 more per month, but you’d spend $11,738 less in interest overall.

You don’t plan to stay in your home for long. If you sell your home too soon after refinancing, your monthly mortgage payment savings won’t exceed what you spent on closing costs.

To find out how long it will take for your savings to offset the expense, divide your total closing costs by your monthly savings after refinancing, and then divide the result by 12. That’s how many years it will take to break even.

You’re close to the end of your mortgage. Early in your mortgage term, you pay more toward interest than you do toward the principal. Toward the final years, you pay more toward the principal and less in interest. It no longer makes sense to pay to refinance when you’re close to paying off your mortgage entirely.

How to refinance

Talk to your current mortgage provider and weigh what they offer compared to other lenders. You’ll need to assemble the same documents you needed to get your original mortgage, which could include:

Proof of income

• W-2s and/or 1099s from the past two years years
• Up to three months of paycheck stubs
• Proof of any additional income (Social Security, child support, alimony)
• Tax returns for the past two years
• Profit and loss statement if you’re self-employed

Proof of assets

• Checking and savings account statements
• Investment and retirement account statements

Proof of other debts

• Car loan statement
• Student loan statement
• Credit card statement(s)
• Current mortgage statement

Other documents

• Proof of homeowners insurance policy
• Proof of title insurance
• A recent assessment of your home’s value