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When is it worth it to refinance a home loan?

Lower your monthly payments and lock in lower rates — but consider all the factors first.

A home is often your largest single asset — and a mortgage is often your largest single liability. Is now the right time to refinance your mortgage?

When it’s a good idea to refinance a home loan

Homeowners often look into refinancing a mortgage to reduce the interest rate on an existing home loan. Locking in a lower rate can save money by lowering your monthly payments and increasing how fast you build equity in your home.

Your monthly payment is too high

For a $380,000 home with a 20% down payment, a 30-year fixed-rate mortgage that has a 4.625% interest rate would have a monthly payment of about $1,563 — excluding taxes and home insurance.

But if you lower the interest rate by 1%, the monthly payment would fall to about $1,386 — assuming the borrower’s financial health and credit history remains the same.

In this example, a 1% drop in interest rate would yield roughly $2,124 in savings per year.

You want to switch to a shorter term

During the first 15 years of a 30-year mortgage, the bulk of a mortgage holder’s payments are on interest. So shortening your mortgage’s term could literally save you tens of thousands in interest.

For example, on a home valued at $380,000, switching from a 30-year fixed-rate mortgage to a 15-year fixed-rate mortgage at 4.625% interest rate would increase monthly payments from $1,563 to $2,345.

While the payments are higher, shortening the home loan’s term would save the borrower $140,565 over the loan’s lifetime. The savings will be even more if a lower interest rate is also locked in when the refinancing occurs.

You want to get rid of PMI

On a conventional loan, PMI (private mortgage insurance) should drop off automatically once you reach 20% equity in your home. However, for FHA loan borrowers, this isn’t the case. Instead, the only way to get PMI once your home’s equity reaches 20% is to refinance to a conventional loan.

You want to switch to a different loan type

Depending on your budget and needs, you may want to go from a variable-rate loan to a fixed-rate and vice versa. For example, if you have a variable-rate loan and the fixed portion of your variable-rate loan has expired, you can refinance to secure a fixed-rate loan with even monthly payments that don’t fluctuate.

My experience with refinancing

My husband and I bought a house we could only afford on two incomes, and I found myself unemployed roughly a year later. So because we were running out of money, we decided to explore refinancing.

I responded to an offer through my mortgage provider, Freedom Mortgage, to refinance my loan, which at that point was only a year and a half old. I qualified for a lower interest rate, which brought my mortgage from 3.8% down to 3.25% and shaved a few hundred dollars from my monthly payments.

Another benefit of refinancing is skipping a mortgage payment — which bought us two months of no payments, and time to figure out my employment situation. I stepped on the gas with my job search and came out lucky in the end with new employment.

Overall, the process of refinancing through the same provider was easy. It waived the closing costs, and everything was done over the phone and with digital document signing.

What to consider before refinancing

Check if your current loan has prepayment penalties

Paying down a mortgage quicker works best if prepayment penalties aren’t part of your current loan. Although prepayment penalties are becoming more uncommon, they still exist and can vary significantly.

Provided you aren’t living paycheck to paycheck, earmarking your tax return or any extra funds available to your mortgage often makes sense. Simply paying your mortgage biweekly — essentially making one extra mortgage payment per year — can yield a big personal return on investment.

For example, if the 30-year fixed-rate mortgage on a $380,000-priced home had a 4.625% interest rate and you made biweekly mortgage payments each year, you would reduce your total payment period by about four-and-a-half years and you save about $45,000 in interest.

Consider the new tax reform changes

Whether you’re refinancing your home loan to cover expenses like a remodeling project or paying for your child’s college education, it’s a move that should be made with extreme caution.

The new tax reform package, signed into law in December 2017, eliminates the interest rate deductibility of some home equity debt. The new tax package also limits certain homeowner’s interest rate deductibility.

However, for new loans in 2019, if you put the money back into your home, you can generally deduct the interest you pay on it. But if you use the money to pay for things like credit card balances or a vacation, you can’t deduct it.

Homeowners with mortgages valued higher than $750,000 are impacted most by this change. Previously, interest rate deductibility was restricted on mortgages over $1 million.

For that $380,000 home with a 30-year fixed-rate mortgage and 4.625% interest rate, the new tax law has no effect. However, there are other changes — on property tax and state tax-deductibility rules — that may be relevant for homeowners.

Calculate your current debt

Many Americans are straddled with high-interest debt. If you have enough equity in your home, refinancing to consolidate that debt into one monthly payment might be a good idea. If the interest rate on a new mortgage is significantly lower than your existing debt, you could save big.

If at all possible, try to keep your loan-to-value ratio below 80% to avoid paying PMI. Also, be aware that your mortgage payments will increase and you’ll likely be extending your loan’s term. Weigh the pros and cons of your particular situation before deciding.

5 things to do before refinancing

1. Determine your break-even point

Because refinancing costs money, it only makes sense to refinance if you plan on staying in the home long enough to recoup the refinance fees. That’s called the refinance break-even point.

To calculate your refinance break-even point and determine if it’s worth it to refinance, you’ll need to divide the refinancing fees by your monthly savings. This number will tell you how many months you need to wait to reach your break-even point after refinancing.

For example, if:

  • Your lender is charging $4,000 to refinance your current loan.
  • Refinancing will save you $250 off your monthly mortgage payment.

The break even point on your refinance is 16 months ($4,000 / $250 = 16 months).

After the 16-month mark you will break even, which means the monthly savings of $250 goes into your pocket. But if you don’t plan on staying in the house for significantly longer than 16 months, it’s probably not worth it to refinance.

2. Calculate your DTI (debt-to-income ratio)

Your credit score, LTV and debt-to-income ratio are the three most important parts of your loan application. But other factors, like switching jobs in the middle of refinancing or taking out a substantial amount of debt during your application process, can threaten your refinancing deal.

Mortgage lenders look at debt-to-income ratios because it shows them how much money a borrower has left after their monthly bills are paid. A debt-to-income ratio above 50% is considered high, while a debt-to-income ratio of 35% or lower is ideal. Calculate your debt-to-income ratio with our calculator.

3. Find out how much it will cost to refinance

Perhaps the biggest mistake people make when refinancing is failing to accurately assess the fees associated with refinancing. Refinancing fees might include an application fee, loan origination fee, appraisal fee, inspection fee, home insurance and closing costs.

These expenses must be accounted for to make sure the savings outweigh the cost of refinancing. The fees associated with refinancing are often about 3% to 6% of the loan amount.

To figure out if refinancing is worth it, consider whether you’ll still be in your home by the time the monthly savings accumulated by refinancing equal the refinancing costs.

4. Shop around for the best lenders

By some estimates, nearly half of customers who take out a mortgage fail to shop around. Usually, the first call that homeowners make when looking to refinance is to their current lender. But shopping around can help you know your options and sometimes get a better deal.

Start your search by going to the Consumer Financial Protection Bureau’s rate checker tool. This tool doesn’t name lenders, but it helps you find the best rates for your profile. With this information in hand, you’ll have a better sense of what to expect when you shop around.

5. Choose your preferred term length

Depending on the provider, you may have a choice between keeping the same number of payments left on the mortgage and dividing the new loan among those payments, or starting from scratch with your original — in my case, 30-year — terms.

For example, if you were refinancing with 25 years left on your loan, you could opt to refinance based on 25 years or 30 years. The advantage to starting over is that your payments may be slightly lower depending on how much you have left on the loan, but then again, you’ll have that many more months of payments in the end.

Refinancing checklist

  • Try getting your credit score above 720, your LTV to at least 80% and attaining a low debt-to-income ratio before refinancing.
  • Be aware of and understand the fees associated with a potential refinancing.
  • Ask questions and shop around.

Questions to ask your mortgage broker

Once you’ve narrowed down the list of lenders you want to approach for refinancing, make sure the lender you’ve selected is a good match by interviewing your mortgage broker or loan officer. Also, make sure the loan product your lender is recommending suits your financial needs and objectives.

Ask your lender these questions:

  • Why is the product they’re recommending a good match for you?
  • What is your new interest rate and repayment terms?
  • What are the total closing costs and fees — and what are they for?
  • What is the expected response time after you call or email?
  • How long will it take to complete the refinancing?
  • Can you review all the documents before closing?

Often, you can judge a mortgage broker’s expertise and helpfulness by how well they answer your questions. The answers to these questions will help you determine the loan product’s suitability and whether it makes sense to refinance now.

Bottom line

When done right, refinancing your mortgage can save you a lot of money in the long run. But it’s a big decision, so carefully consider all your options before signing the dotted line.

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