The question of when to refinance your mortgage is not a simple one. Many things must first be considered before the decision is made. If you are not careful, refinancing can actually hurt your bottom line rather than help it. With this in mind, let us take a look at some of the issues you may encounter when trying to decide to refinance and some reasons why you may or may not choose to do so.
The most common reason why a person will think it is time to refinance a mortgage is when they believe that they can reduce their monthly payment or interest rate. This may or may not be the right time to take such an action.
If a person has an adjustable rate mortgage (ARM), they may want to switch to a fixed rate mortgage. Many times, it is the case that the ARM rate has risen from its initial low point and now a fixed rate mortgage actually carries a lower rate. Other times a person may have a fixed rate mortgage that they obtained many years back. Over time, they have improved their credit score and they now have the ability to obtain a lower interest rate. Still other times the state of the economy is such that lower rates are generally available.
In any case, one should not judge the book by its cover. Most importantly, you have to realize that refinancing is not free. First, you will have to pay a fee for applying for a refinance. This pays the cost to run a credit check on you. Then there is the cost for the lender to check your title and get title insurance. Next, you will need to pay for the borrower’s lawyer. You will likely want a lawyer for yourself. There will also be other legal fees. Finally, you will need to pay points, taxes and an origination fee. Points can be especially confusing and you can learn more about them here. There may even be other costs not mentioned above.
Cost of Refinancing
In the end, the decision of whether or not to refinance in order to reduce payments comes down to math. You need to calculate all of the closing costs regarding the refinancing. Then you need to look at how much money you save each month after you refinance. Next, you consider how many months it will take for the money you saved to pay for the costs you incurred. If it turns out that you will be remaining in your home long enough to cover the costs of refinancing, then you should refinance. You can use the free mortgage calculator at Credit Sesame to help you figure out if you should refinance.
Example: You incur $10,000 in closing fees while refinancing and in the end, you save $500 a month. It would take you 10 months to recoup the costs of refinancing. If you will be remaining in the house for more than 10 months, you should refinance.
Another consideration you must be wary of is a clause in your original loan that penalizes you for paying it off early. When you refinance a mortgage, you are actually paying off the original loan and taking out a new one. Therefore, if there is a penalty for paying off the original loan early you will incur that penalty by refinancing.
Finally, you must realize that if you decide to refinance a 30-year mortgage to another 30-year mortgage you may be paying less monthly but besides paying for a longer period of time, you are also paying more in interest. In this case, whereas the cost is less monthly, the overall cost is greater.
The way a mortgage works is that you pay more of the interest at the beginning of the mortgage. So if, for example, you have a 30 year fixed rate mortgage for $200,000 at 5% interest, your monthly payments would be $1,073.64. However, that payment is broken up differently between interest and principal depending on how long you have been paying. Your first payment of $1,073.64 would consist of $240.31 in principal and $833.33 in interest. In contrast, your final payment would consist of $1,069.19 in principal and $4.45 in interest.
Now consider that since you are paying more interest than principal initially, you will not have even paid off half of your loan after 15 years. If you were to refinance halfway through your first mortgage you would be taking out a mortgage to pay off more than half of what you borrowed initially and on top of that, the initial payments for the new loan will again be mostly interest. It is clear that refinancing for the same loan term can cost you a lot in interest.
One way to ease this problem is to attempt to get a loan that will end at the same time as the original loan. The reduced rate will not be as low as it would have been had you extended the time frame out another 30 years, but if you have a good credit score and some equity in your house then you will still likely get lower monthly payments without bleeding interest.
Attention to Details
All of the above is not to say that you definitely should not refinance to a lower rate. As often as not, you will actually save money in the long run. You just need to pay careful attention to all of the details before you make the decision to refinance or you could wind up in trouble. Never be afraid to ask questions of the lender and do not sign anything until all of the terms and conditions are clear in your head. With careful attention to detail, you could end up saving substantially.
In the end, the decision of whether to refinance is a difficult one. If you feel bogged down in the mire and would like some helpful information that will make the choice easier you could check out Credit Sesame.