Four Hurdles to Clear Before Refinancing

To refinance or not to refinance – that is a question many people ask themselves at some point during their homeownership journey. While it may seem like a no-brainer to opt for a lower interest rate, there are a few initial steps you should take before you decide whether it’s a good time – and a good option – to refinance.

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Establish Your Goal

  • For most folks, the goal of a mortgage refinance is to reduce monthly bills. Interest rates may be lower, and your credit score may be higher than when you first financed your loan. A higher credit score may qualify you for a lower interest rate which can save you money on your mortgage payment each month.
  • Looking to shorten the length of your loan? For example, if you’re planning for retirement and don’t wish to have a mortgage payment once you hang up your spurs, the switch from a 30-year to a 15-year mortgage may be a reasonable objective. Bear in mind that with a shorter term you will need to look at the numbers carefully as your payments will probably be higher – even if interest rates are lower. You want to be certain you can handle this expense for the length of the loan – you haven’t worked this hard to find yourself house poor and having to struggle.
  • In another scenario you may be tired of the roller-coaster ride an adjustable rate mortgage takes you on from one year to the next. Your aim may be to secure a fixed-rate loan so there are no surprises.
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Examine Potential Costs Involved

A good rule of thumb is to go into a refinance knowing that closing costs will typically run about 2% to 5% of the total loan value. They often include things like a processing/underwriting fee, appraisal fee, loan origination fees, title/attorney fees, flood determination fee, escrow reserves for property taxes and insurance, discount points for a lower interest rate and credit report fee. If the refinance can lead to significant savings, you could break even on the money you put toward closing costs within a matter of months. However, if the savings are less than stellar, it could take years to break even so you need to determine how long you plan to stay in your home and if it will be worth the expense. Let’s say your closing costs are $5,000, but you’ll be saving $250 a month. A little math will tell you it will take you 20 months to break even on your refinance.

Identify How Much Equity is Available

If you’re using a cash-out refinance of your mortgage for something like putting on a new roof, adding a pool to your backyard landscape or paying off credit cards, be sure to leave at least 20% equity in your home to avoid paying private mortgage insurance (PMI). While it may seem like a good idea at the time, if you gobble up all of your equity, you might end up costing yourself more money in the long run between PMI and adding more years to the life of your loan. Depending on the amount you cash out, refinancing a 30-year mortgage could easily stretch it into a 40- or 45-year loan. And don’t forget, you’re resetting the clock on your amortization schedule – so you could spend years paying off the interest of your refinanced loan before you’ll even touch the principal. If the value of your home has dropped significantly over recent years – diminishing the available equity, a refinance may not be in the cards at this time. You might want to explore a personal loan or home improvement loan instead.

Do Your Homework

If you have the time and energy to devote to this pursuit, you might want to consider exploring all your options with more than one mortgage lender to find the right alternative for you and your circumstances. It can seem a bit overwhelming at first, but a well-researched refinance could save you money on your monthly mortgage payment or convert that ARM for a fixed-rate mortgage at a lower APR for peace of mind from unexpected changes to your payment.

A good place to start on your refinance journey is to have a solid understanding of the building blocks of a mortgage. This article could prove helpful.