How to know when to refinance your mortgage

  • By Ellen Chang,
  • Bankrate.com
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Homeowners who are considering refinancing their mortgages have one advantage to count on – interest rates remain low.

Refinancing from a 30-year or adjustable rate mortgage (ARM) to a lower rate can help consumers save money each month and cut the total amount that goes towards interest payments.

Here’s how to determine whether you will benefit by refinancing your mortgage.

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Here are the two major types of refinances:

  1. Rate-and-term refinancing to save money. The majority of homeowners refinance the rest of the balance on their mortgage for a lower interest rate and an affordable loan term. (The loan term is the number of years it will take to repay the loan such as 15 or 30 years.)
  2. Cash-out refinancing where you obtain a new mortgage for more than what you owe. The difference is often used to pay for renovations or to retire credit card debt.

Other reasons consumers refinance include to replace an adjustable-rate mortgage with a fixed-rate loan, eliminate FHA mortgage insurance or to settle a divorce.

Some consumers refinance to lower their monthly payment and have more money each month for bills, groceries or an auto loan.

“If a borrower is refinancing strictly to lower monthly mortgage payments and closing costs are $2,400, the borrower should expect to save at least this amount in interest payments for the duration they plan to have the loan,” says Richard Liu, a mortgage consultant for C2 Financial Corp., a San Diego-based mortgage brokerage.

Determine how long it will take to break even

Mortgage closing costs add up to thousands of dollars. To decide whether a refinance makes sense, calculate the break-even point, which is the time it will take for the cost of the mortgage refinance to pay for itself.

“If you can shave one-half to three-quarters of a percentage point off your mortgage loan by refinancing, you should look into it,” says Greg McBride, CFA, chief financial analyst for Bankrate. “Just be sure the cumulative savings on monthly payments is enough to offset the costs of refinancing. If you’re planning on moving in the next year or two, it might not.”

Break-even point example

Break-even point = Total closing costs ÷ monthly savings

Example:

30 months to break even = $3,000 in closing costs ÷ $100 a month in savings

If you plan to keep the house for less than the break-even time, you probably should stay in your current mortgage.

Mind the term in rate-and-term

The formula above doesn’t measure your total savings over the life of the new mortgage. A refinance can cost more money in the long run if you start your new loan with a 30-year term.

Example:

Kris has been paying $998 a month for 10 years. If Kris doesn’t refinance, the payments will total $239,520 over the next 20 years.

With a refinance, Kris could pay $697 a month to repay the new loan in 30 years, or $885 a month to pay it off in 20 years.

$697 x 360 months = $250,920

$885 x 240 months = $212,400

In the example above, Kris borrowed $186,000 at 5 percent. 10 years later, Kris had a remaining balance of $146,000, and refinanced at 4 percent.

Pros and cons of cash-out refinances

Cash-out refinances often are used to pay down debt. They have pros and cons.

Imagine that you use a cash-out refinance to pay off credit card debt. On the pro side, you’re reducing the interest rate on the credit card debt. On the con side, you may pay thousands more in interest because you’re taking up to 30 years to pay off the balance you transferred from your credit cards to your mortgage.

But the biggest risk in this scenario is in converting an unsecured debt into a secured debt. Miss your credit card payments, and you get nasty calls from debt collectors and a lower credit score.

Miss mortgage payments, and you can lose your home to foreclosure. Home equity debt that’s added to the refinanced mortgage always was secured debt.

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