A refi could cut your monthly mortgage payment, but that doesn't necessarily mean it's the right move.
Even though rates spiked after the election and may rise further after the Fed meets December 14, there are about four million borrowers who will still benefit from refinancing, and of that, two million borrowers could save $200 or more per month by refinancing.
There are many reasons to refinance, but here’s what you should know before you act.
Refinancing costs money
There’s no such thing as a free refinance. You’ll need to pay closing costs, which typically run anywhere from 2 to 5 percent of your loan amount. So, if you’re refinancing a $150,000 loan, you might pay between $3,000 and $7,500 in closing costs upfront.
One option you have is for your mortgage lender to cover the closing costs using a no-closing cost refinance. But if you go that route, you’ll pay a slightly higher interest, says Ray Rodriguez, regional mortgage sales manager at TD Bank.
Therefore, “you need to calculate your time horizon,” says Rodriguez.
Before selecting a no-cost refinance, look at what the closing costs would be if you were paying for them separately, then calculate how long it would take the monthly payment savings from a refinance to repay the closing costs. Once you do that you can more accurately determine whether a no-closing cost refinance is mathematically sound for your situation.
Use a refinance calculator to see how long it will take for you to recoup the closing costs. If your breakeven point is four years but you only plan to stay in the home for two years, refinancing isn’t a smart move.
Savings should repay costs quickly
Refinancing makes sense when your interest rate on your mortgage is more than 100 basis points above current interest rates, says Todd Sheinin, a mortgage lender and chief operating officer at New America Financial in Gaithersburg, MD.
Of course, everyone has different objectives, so there’s no hard and fast rule on how much you should save, but generally your refi costs should be recouped in about two years or less.
For example, if you got a 30-year fixed loan of $200,000 loan in March 2011, your rate would have been 4.83 percent, according to Freddie Mac. This week that rate is 4.13 percent.
So if this refinance cost you $2,800 and saved you $179, your savings would repay the closing costs in 15 months. This means that after one year and three months, you’d truly benefit from the lower payment — a very favorable refi scenario.
In contrast, if you got that same $200,000 30-year fixed loan in August 2013, your rate would’ve been 4.45 percent. So if you paid $2,800 to refinance into this week’s rate of 4.13 percent and only saved $93, your savings would repay the closing costs in 30 months.
This is six months past the two-year mark, so it would take a while to truly benefit from the refi. But some may deem the $93 per month savings meaningful enough to refinance. This is a discussion to have with your lender.
Before you commit, be sure to do your homework and compare refinance rates from multiple lenders.
A refi could cancel your PMI
If you’re currently paying for private mortgage insurance (PMI) on your loan but have gained a substantial amount of equity in your home, refinancing could enable you to cancel your mortgage insurance.
Your loan balance must be 80 percent or less of your home’s appraised value in order for this to work, says Richard Redmond, mortgage broker at All California Mortgage in Larkspur, CA and author of “Mortgages: The Insider’s Guide.”
If your first mortgage is 80 percent or less of your home’s value when it’s appraised for the refinance, your new loan wouldn’t require PMI, and this new loan would replace the loan with PMI, thus cancelling your PMI obligations.
You’re rewinding the clock on your loan
When you refinance, you’re effectively resetting the life of your home loan. So if you’ve had your loan for many years, you’ve reached a point in your loan where most of your monthly payment is going to paying the loan down (rather than paying interest). Refinancing the loan will change this dynamic, so most of your payment is going to interest rather than paying your loan down.
Ask your lender to do a side-by-side loan amortization comparison so you can see how fast you’ll pay off your existing loan versus a new loan. Also ask them to show you how much faster you’d pay off the new loan if you took the savings from a refinance and applied it as an extra monthly pay-down on the new loan.
Your equity could be a good source of cash
A cash-out refinance lets you take out a new mortgage for more than the amount you owe on your current loan and then pocket the difference — typically up to 80 percent of your loan-to-value ratio. That can be a good move, depending on how you’re planning to spend the money, says Rodriguez.
If you’re going to use the cash to build an addition to your home that’s going to increase your property’s value, taking a cash-out refi makes sense. But keep in mind that cash-out refinance rates are slightly higher than rates for non-cash-out refinances.
If you’re going to use the money for discretionary spending, such as a vacation, think twice. It’s not advisable to use cash out proceeds for discretionary spending, although lenders don’t prohibit you from doing this.
One caveat: If home values in your neighborhood are decreasing, now may not be the right time to tap your equity. “Before you pull equity from your home, you need to weigh the costs and benefits,” Rodriguez says.
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