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Should You Refinance Your Home Mortgage?
Published: 05/23/2011 by Kevin Mulligan
Refinancing your home's mortgage is a great way to save money over the long-term. You will get a lower rate and lower payments. But is refinancing always a good idea? Let's investigate how to determine whether or not you should refinance your home.
What is refinancing a mortgage?
To understand refinancing, just break down the word. You are re- (again) financing your home. When you first purchased a home you probably paid for part of the home with a down payment. You financed the rest through a bank with a mortgage.
By refinancing you are financing your home again. This is normally done to lower your interest rate (and thus your monthly payment) or to pull cash out to be used in other ways.
But be careful. Refinancing is not always a good financial move.
When does refinancing help? When is it a bad idea?
Refinancing is a smart financial move if:
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you can lower your interest rate significantly
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you plan to live in the home for a long time
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you have enough equity in your home to refinance
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you have cash available for closing costs
If you don't meet the above criteria then refinancing probably isn't the best idea. You need to be able to drop your interest rate significantly – at least 1%. If your current rate is 6% and you can only refinance to 5.75% then you are better off sticking your current mortgage.
The goal is to see how much lower your monthly payment is. Then compare your closing costs to the monthly difference. See how long it takes to “pay back” the closing costs. The difference you will save in your monthly payment by saving 0.25% will be so small that you will probably never pay your closing costs back.
Even if you could move your rate down significantly, there is no point to refinancing if you do not plan to live in the house very long. Again, you need time to go by with a lower monthly payment to offset your closing costs. If you refinance today and move in a year, then you've lost money on the deal.
To refinance you must also have equity in your home. The bank that refinances your home – whether it is the same bank you have your original mortgage with or not – will require you to have some skin in the game. If you have less than 20% equity in your home, refinancing will be difficult. The bank is wary of lending you too much money, having the house value fall dramatically, and you walk away from the mortgage or sell the house and not be able to pay the full amount off. The amount of equity in your home is used in the loan-to-value ratio, where the bank looks at what percentage of the value of the home is financed versus equity.
Lastly, even though you might have enough equity in your home, it isn't wise to roll your closing costs into the refinancing loan. You will be increasing your loan-to-value, losing equity, and walking down the line of always using debt to pay off debt. It is better to save up a little bit of money to refinance and pay the costs out of pocket.
Calculate how long to pay back closing costs
Calculating your break-even point of refinancing is easy. All you the variables you need are: your current monthly payment, your new monthly payment, and the closing cost total.
Let's say your currently monthly payment is $1,000, and by paying $2,000 in closing costs you could drop your payment to $975. You would save $25 per month.
To pay back that $2,000 in closing costs you would have to stay in the home for 80 months ($2,000 divided by $25). That's a little more than six and a half years. If you stay longer than that time, you come out ahead. If you sell the home before then, you lost money by refinancing.
