The good news about low mortgage interest rates means a lot of home owners are seriously thinking about refinancing their home loans. In many cases, refinancing may make sense. But, it can turn out to be an expensive proposition unless you approach it with careful consideration.
It may seem like a dumb question, but we’re not ignoring the fact that loan rates have dropped below four percent. We’re asking in order to focus your attention on just exactly what you want to accomplish by refinancing and help you decide whether it’s your best move.
It’s important to remember that by refinancing a mortgage you’re not likely to be reducing your debt. In fact, you could easily be increasing your debt dramatically. Instead of reducing debt, you are restructuring debt, at a lower interest rate and at a different loan term than your current mortgage — possibly extending the financing again to 30 years.
One reason home owners refinance is to escape their adjustable-rate mortgage (ARM). For many, there’s a secure feeling that comes with locking in a 30- or 15-year fixed rate over the life of the mortgage loan.
Consolidating debt is another goal of refinancing. Combining both a first mortgage and a home equity loan into one fixed-rate mortgage can even out the payments and simplify finances.
Perhaps the most important reason to refinance is to reduce what you’re paying on interest. But here’s where the question gets a little tricky. It’s easy to confuse simply reducing the monthly payment with the long-term reduction of interest owed and total debt. The real question you should be asking is whether refinancing will save you money overall in the long run.
Lower monthly payments vs. Reduced interest expense
Once you’re sure of your goals for refinancing a mortgage, you need to consider your timing and circumstances.
Remember, true savings come from reduced interest expense, not lower monthly mortgage payments. If you get a lower interest rate but extend the mortgage term, you can wind up spending more in interest in the long run. Substituting a mortgage that has 20 years remaining with a 30-year mortgage will result in higher interest expense over the life of the new loan.
If your goal is a more affordable monthly mortgage payment, a lower loan rate or longer loan term will both work. Just understand you may not be reducing total interest expense.
If your goal is to get out of an ARM or interest-only mortgage (where the borrower only pays interest on the principal balance), refinancing to a fixed rate loan will work. But if you don’t plan on being in the loan (your house) for very long, it won’t be worth it.
And, if your goal is consolidating debt, refinancing to a single loan will work.
Make some calculations
When weighing whether to refinance, calculate how many months of lower payments it will take to recoup the closing costs of the new mortgage. Closing costs can amount to $2,000 on each $100,000 financed.
Obviously, you have to plan to be in the house for a while for refinancing to make sense. If you don’t plan to be in the house for very long, you should probably stay in your current mortgage. So, the number of months it takes to recoup closing costs is a key calculation. (Use the refinancing calculator below — just be sure to click “refinance.”)
Type of refinancing?
You have a choice in the type of refinancing you are going to do: cash-out or standard, in which you are just refinancing the existing mortgage balance.
In a cash-out refinance, you take out a new mortgage in which the amount borrowed is greater than the amount of the original mortgage. The difference is taken out in cash. A cash-out refinance will typically have a slightly higher interest rate because the lender has more money at risk.
Prepare your credit for refinancing
Before you refinance, get up-to-date on your current mortgage — including loan rates and term, as well as any special stipulations. Also, know your credit score (you can get it for free) and clean up your credit report. Getting your credit history and credit score in the best possible shape will help you get a better mortgage rate.
If you’re currently underwater on the house, you should look into refinancing under the government’s Home Affordable Refinance Program (HARP).
Interest rates are at an all-time low, so now is the right time to refinance your home if you are looking to stay in your home long-term and want to save money, overall. Keep in mind there are costs associated with refinancing, such as closing costs and junk fees.