Should I refinance my mortgage?

Interest rates are at historic lows. Many people wonder if they should consider refinancing their home. How do you know how much the lower interest rate saves you? How much do you have to lower your rate to make it worthwhile? What kind of mortgage should you be looking at?

If you currently have a home mortgage these are great questions to be asking right now.  Mortgage rates are currently at lows that most of us have not seen in our lifetimes. It is a great time to try to lock in a fixed rate. Honestly with national averages on a 15 year fixed rate dipping under 3%, rates really can’t get much lower.

Where do you start?

So if it is a good time to refinance, where do you begin? First you’ll want to know what interest rate you are currently paying. You should be able to find that on one of your mortgage statements, or you can call your lender. Now you want to check to see what kind of rate you might be able to get.

If you are happy with your current lender you can talk to them about what options you have for refinancing and how much you could lower your rate. Bankrate is another great place to find and compare available rates. You can enter your city and state and the amount you want to refinance and the site will list available rates and closing costs.

What are typical closing costs for a refinance?

Closing costs are all of the costs that are associated with completing your loan. Generally speaking, you can expect to pay somewhere between 3% to 6% in closing costs. So if for example you are borrowing $100,000 you can expect to pay about $3,000 to $6,000 in order to refinance the loan. Closing costs will include things like bank origination fees, application fees, attorney fees, home inspection, appraisal fees, title search and title insurance, and possibly survey fees.

So how much do I need to lower my interest rate?

Sounds good but if you have to pay these fees then how much do you need to lower your mortgage rate for it to make sense? This is actually a fairly simple calculation to make. It is really going to depend on how long you plan to stay in your current home. Let’s say that you intend to borrow $100,000 and currently your interest rate is 5%. Your new interest rate will be 3% just to keep nice round numbers.

That means that if your current balance is $100,000 at 5% then you will be paying about $5,000 in mortgage interest this year. (100,000 * .05 = 5,000)

If you refinance then you will only be paying $3,000 in interest (100,000 * .03 = 3,000). Therefore by refinancing you are saving about $2,000 a year. ($5,000-$3,000)

Now let’s suppose your closing costs to refinance are approximately $4,000. If you are saving $2,000 a year in interest then you’ll need to stay in your current home for more than 2 years to save enough on interest to cover those closing costs.

There are some other considerations that play slightly into this like mortgage interest tax deductions, but if you do these simple calculations, you should get a pretty good estimate of how long you need to plan to stay in your current home so that your interest savings will outweigh the closing costs.

If you have significant equity in your home, you may be able to get the bank to waive some of the closings costs. For example, if your home is worth $300,000 but you are only looking for a $75,000 mortgage, you might be able to avoid getting an appraisal as obviously anyone driving by could see the home is clearly worth significantly more than the mortgage. This is just one example. Never hurts to challenge these costs and see if you can negotiate some of them down.

Some other considerations

It may be possible to roll the closing costs into the loan, but generally this isn’t a wise move. If you do so then you are basically agreeing to pay interest on those closing costs for 15-30 years. That’s not a good financial move.

If you have been making payments on your mortgage for several years, be careful about refinancing for the same term as your original mortgage. During the first few years of your mortgage, your payment is almost all interest. Say you had a 30 year mortgage that you had been paying on for 11 years. Refinancing it into another 30 year mortgage would mean you are going to be right back to paying almost exclusively all interest on your monthly payment. It might still be a good idea to refinance but consider financing it to a 20 year mortgage or better yet a 15 year mortgage.

Make sure that your existing mortgage doesn’t have any prepayment penalties. You can check with your lender if you are unsure. If there are, it might still be wise to refinance, but you should add these penalties to your closing costs when doing the above calculation. You might also be able to work with your existing lender to refinance with them and avoid having to pay the penalties. Again there is no harm in asking.

Along the same lines you want to be sure your new loan does not contain prepayment penalties or balloon payments that come due in a certain number of years. You also want to make sure your new loan is a fixed rate loan. Adjustable rates are almost always a very bad idea anyway, but at a time where rates are at all-time lows, it isn’t hard to predict which direction your loan would be likely to adjust.

If you currently have a 30 year loan, think strongly about refinancing to a 15 year loan. Often the payment isn’t significantly more and you will save thousands of dollars in interest. Many people make the argument that they’ll get the 30 year mortgage in order to have the lower payment in case something happens, but they’ll pay it like a 15 to get it paid off. That will work if you are extremely disciplined. The problem is “something” almost always happens, and you’ll find month after month “something” eats up that extra payment amount so you don’t really make the progress you intended. One thing about a 15 year mortgage, amazingly they always pay off in 15 years!

You also want to make sure your mortgage is no more than 80% of your home’s value. This will ensure that you do not have to pay PMI, which is private mortgage insurance. This is insurance that protects the lender in the event of a foreclosure and is generally required when the loan is more than 80% of the value of the home. Since home values have declined in recent years it is possible you might not have as much equity as you’d like even if you have been paying on your mortgage for several years.

Never been a better time to refinance

If…

  • You are planning to stay in your home for a few years.
  • You currently have enough equity in your home
  • Your interest rate is a little high compared to today’s rates

It is a great idea to run to your lender and look into refinancing. There has never been a better time. It is almost impossible for rates to drop any lower. Lock in a great interest rate now and you’ll thank yourself when rates eventually start to go back up. You might save yourself several thousand dollars!

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