Refinancing your mortgage isn’t always worth it.
This is because sometimes, the process can be long, drawn out, and complicated. And, worst of all, you might not even save any money in the long term. To make refinancing your mortgage worth your while, there is a very specific rule of thumb that you need to follow.
If you can’t lower your interest rate by at least this perfect number, you should plan to stay with your current monthly payment as it doesn’t make sense to refinance.
What does it mean to refinance a mortgage?
When you refinance your home, it means you are applying for a completely new mortgage loan. Whether you remain with your original lender or pick a new company entirely is completely up to you.
However, you’ll need to think way back to when you first purchased your home. When you took out your original home loan, you will remember all of the documentation and paperwork that it took to obtain it.
When you refinance, you are agreeing to go through that same process again. The only difference is that have you now have higher equity in your home. This means that the bank will own a significantly less portion than it did at closing. This is because you earned a larger and larger stake in your home with each mortgage payment you made.
So, you’ll need to provide your lender with the same sort of documentation, like a credit score, proof of income, etc.
How much does it cost to refinance a mortgage?
The main purpose of refinancing your mortgage is saving money. When deciding whether or not to refinance, you should be thinking about long-term monthly savings.
That is, are the costs associated with taking out a new mortgage worth it in the long term?
The Federal Reserve Board says it’s not unusual to pay 3-6% of your total loan balance in refinancing fees.
Here are the costs of refinancing a mortgage:
This charge covers the processing of your loan request and credit report. Sometimes this is called an “origination charge” and also includes the underwriting fees.
It also covers the cost of processing your loan request and running your credit.
This charge covers the fees for the professional who makes sure the value of your home can support the loan.
Some US states require that a real estate attorney be present at the proceedings.
The fee you pay for the notary public to witness your signature.
Money paid to the lender to bring down your interest rate.
If you refinance your mortgage in the middle of a payment cycle, you need to pay the interest for the rest of it up front.
Private Mortgage Insurance and Title Insurance
Just like when you took out your first mortgage, you have to insure the loan and your claim to it as well.
Even though you did a title search when you first bought your house, because refinancing means you are taking out a brand new loan, you will have to do another one.
When is it a good idea to refinance a mortgage?
After considering the costs listed above, if you still think you will be able to save money with new loan terms, you can move forward with refinancing.
He are the most common reasons that people refinance their mortgage:
Lower Interest Rates
When interest rates are down in general, many homeowners begin to think about refinancing their home to take advantage of the lull in the market.
Higher Credit Score
Let’s say you’ve opened a few new credit card, have kept up with your monthly payments on all your debts, and are overall doing a better job of managing your credit.
If your score is significantly higher than when you first purchased your home, then you might qualify for a significantly better mortgage.
New Mortgage Type
Let’s say you have an adjustable rate mortgage (sometimes called a ARM). When you first bought your home, it worked out great. This is because at the beginning, these mortgages usually have lower interest rates than traditional fixed-rate mortgages.
But after the introductory honeymoon period, rates can sometimes start to rise and pull your monthly payment up with it. When this happens, many homeowners prefer to switch over to a fixed-rate for more stability.
When is it a bad idea to refinance a mortgage?
The following scenarios are not necessarily bad reasons to refinance your mortgage. You will just need to proceed with caution to ensure you are making the right choice for you.
Lower Monthly Payment
Sometimes you need a lower monthly payment to make sense for your current budget. So, let’s say you’ve owned your home for 10 years and have a 30-year mortgage. Your monthly payment is just a little bit too high to suit you.
So, you opt refinance into another 30-year mortgage. Only this time, it will be for a smaller amount since you’ve already paid 10 years worth on your first loan. Your monthly payment will now be smaller, but since you are technically extending your loan term, you will pay more in interest in the long run.
Cash Out Equity
If you have a lot of equity in your home, you might want to borrow against that equity to finance other life events, like a wedding, college education, or significant home improvements.
Most people do this because the fees and interest for a mortgage can often be less than on other types of loans. However, by taking out a new mortgage and spreading the payments out like this, it can still end up costing you more in the long run.
What is the rule of thumb to refinance a mortgage?
The typical rule of thumb, the magic perfect number, is at the very least, 1%. You should not refinance if your interest rate will not drop by at least a point. And, if you can, two.
To decide if you can refinance or not, be sure to use a refinance calculator to understand your loan terms and how quickly you will reach the break-even point. This is when you start saving more money than you spent on the process.