When Should I Refinance My Mortgage? 5 Common Reasons To Refinance
By Mark B. Huntley, Esq.
Last Updated 9/4/19
Summary: Refinancing your home mortgage can save you tens of thousands of dollars or cut years off the length of your loan, but there are instances when it may not be the best financial decision.
Lower Interest Rate
When interest rates drop below your current mortgage rate, it is only natural to wonder if refinancing makes sense for you.
As a good rule of thumb, the Federal Reserve Bank of San Francisco recommends that you consider 'refinance(ing) every time the mortgage rate drops by 50 basis points.'
To put this quote in perspective, one hundred basis points are equivalent to 1% and fifty basis points are equal to ½ a percent or 0.5%.
Buying points is an additional option you can consider when refinancing your mortgage.
Usually, buying points makes sense if you plan on owning the home for over half the length of the mortgage.
Bank of America advises, 'In general, the longer you plan to own the home, the more points help you save on interest over the life of the loan. When you consider whether points are right for you, it helps to run the numbers.'
Points chart found at BankofAmerica.com
Combining an already lower interest rate with a calculated points purchase can help push the amount of interest you pay over the life of the loan to the minimums.
Getting a free quote to see your options is the first step to take when current interest rates have dropped below the rate you are paying for your mortgage.
Shorten The Length Of Your Mortgage
Another good reason to refinance your home is to shorten the length of your mortgage.
Here's how it works…
When you refinance with a lower interest rate, your monthly payments go down.
However, another option is to keep the same monthly payments and apply the interest savings to the loan balance, which will lower the length of your loan.
Switching from a 30-year loan to a 15-year loan results in higher monthly payments but pays the loan off much more quickly, saving thousands of dollars in interest payments over the life of the loan.
Discover explains in their Refinancing 101 article.
For instance, if you had a 30 year fixed rate mortgage at 9% on a 100k home mortgage, your monthly payment would be $804.62.
By refinancing that same mortgage at 5.5% with a monthly payment of $817.08, you could cut the length of your loan in half to 15 years.
That is a cost savings of almost $150,000 in interest that you would not have to pay, by refinancing.
Convert From An ARM To A Fixed Rate Mortgage
ARMs or adjustable-rate mortgages have a fixed rate for a period of six months to ten years, and then their interest rate is adjusted annually based on the market index.
Adjustable-rate mortgages tend to have an enticingly lower interest rate than a traditional 30-year fixed-rate mortgage.
However, at the end of your fixed-rate period, the interest you pay will be determined by the amount you agreed to pay over the market index.
If interest rates have risen, then your monthly payments will increase to cover the additional interest.
Be careful when considering Adjustable Rate Mortgages that include prepayment penalties designed to take back all of the interest you saved.
When interest rates begin to rise, it is a good idea to lock in a fixed-rate mortgage for cost certainty and to eliminate the chance of future interest rate hikes.
ARMs are usually used by people who don't plan on owning the house for more than a few years or who want to take the immediate cost savings.
Before choosing an ARM, it would be wise to speak to multiple mortgage lenders about the pros and cons of this mortgage option.
Cash-Out Refinance & Consolidating Debt
The first three mentioned reasons to refinance make financial sense, and I think people can see the savings pretty quickly.
With Cash-out refinancing or consolidating debt, the cost savings may be more challenging to see or may not be there at all.
There is a multitude of reasons why you may want to take some equity out of your home when you refinance your mortgage.
Some of the common reasons we have heard for refinancing are; to remodel the home, pay for a child's college tuition, pay off credit cards, or start a new business.
The three main justifications given for Cash-out refinances are:
- 1Remodel Adds Value To Home
- 2Lower Interest Rate Than On Another Loan
- 3Mortgage Interest Is Tax-Deductible
There is no reason to have to justify a cash-out refinance, but there may not be a lot of financial logic for the above purposes.
Many remodeled homes have very custom features added for the present owner's enjoyment or comfort.
However, some of these 'perfect' additions may not be popular with the future home buyer and can decrease the value of the house.
A CNBC study found that on average you will recapture only 56% of your remodeling costs.
Paying off your high-interest rate credit cards with a low-interest rate refinance loan on its face sounds like a good idea.
However, home mortgages tend to have lengths of 15 to 30 years, which means that you will pay interest on that credit card debt for a much longer time.
Most financial experts highly advise against refinancing your mortgage to pay off credit card or other unsecured debts.
Yes, mortgage interest is tax-deductible, but spending an extra dollar in interest to save 25% in taxes is a losing proposition.
Before refinancing your unsecured high-interest loans into your home loan, try finding a balance transfer credit card with a 0% introductory offer and move the debt year to year until it is paid off.
Take The First Step
Regardless of everything we discussed above until you request a quote, you won't really know what your options are.
Keep in mind that just because you request a mortgage refinance quote, there is no obligation to move forward.
Not only should you request a quote today but you should request multiple quotes from multiple lenders to be sure you are getting the best deal.
The Consumer Financial Protection Bureau (CFPB) suggests that you, 'Ask each lender for the same kind of loan with the same features.' Or you won't be able to compare 'apples to apples.'