Refinancing takes time and money, so you can't realistically do it every time interest rates go a little lower, or just to have bragging rights at your next cocktail party. How, then, do you determine when a mortgage refinance makes sense? Try this step-by-step approach, and you'll find the decision can be an easy one.
Refinancing a Mortgage: Define Your Needs
Homeowners refinance to improve on the terms of their current mortgages. So your first step is to define what exactly you want to accomplish. You may want to refinance to:
- Take advantage of a drop in interest rates.
- Replace an adjustable-rate mortgage (ARM) with a fixed-rate mortgage (FRM) for payment stability.
- Replace your FRM with a lower-rate ARM or hybrid ARM.
- Convert a subprime or Alt-A mortgage into a conventional mortgage.
- Stretch out the balance over a longer repayment period to achieve a lower mortgage payment.
- Reduce your term to retire your mortgage sooner.
- Consolidate high-interest consumer debt.
- Convert equity to cash for renovations, investments, or other big-ticket purchases.
- Convert equity to cash to supplement retirement income.
Match a Mortgage Product to Your Needs
There's a reason for the many different mortgage loan products out there. They have been developed to help homeowners meet very different needs when they refinance their home loans. For each of the needs listed above, there are ways to refinance.
- You may be able to lower your interest rate at a low cost with a streamline refinance. Ask your current lender about this product.
- Switching to a fixed rate from an ARM may mean increased monthly payments, but doing so does offer stability. A hybrid ARM, which may be fixed for 1 to 10 years, can carry a significantly lower rate than a 30-year fixed-rate mortgage .
- Switch from your fixed-rate mortgage to an ARM for the greatest short-term savings.
- If you are in a subprime loan now, you should be working to clean up your credit and monitoring your credit score. Anyone refinancing with credit challenges should look into FHA mortgages first.
- Stretching your balance over a new term can lower payments even without a huge interest rate reduction. If you have been paying down a 30-year, $300,000 loan for the past 5 years at 5.5%, getting a new 30-year loan at the same rate would drop your payment $128. If you were to get a rate of 5%, your new payment would be $214 lower, and by choosing a 40-year term, you could pay $272 a month less. However, you do pay more total interest over the life of the loan.
- Shorter mortgage terms, such as a 15 years, have a couple of advantages--a
lower rate and faster payoff. If this is your objective, refinance only if you can get a lower rate than you have. Otherwise you can simply accelerate your mortgage payoff on your own without incurring the expense of refinancing, assuming your mortgage has no penalty for early payoff.
- Consolidating consumer debt with a mortgage refinance can mean much lower monthly cash outflows. If you already have a good interest rate (compare your current loan rate to today's mortgage rates to see if that's the case), a fixed-rate second mortgage makes sense because it's cheaper than a cash-out refinance.
- Those who want to use their home equity for a large purchase face a similar choice as someone who is consolidating consumer debt. Choose a home equity loan if you like your current mortgage, a cash-out refinance if you don't. To maximize your cash out, look into FHA loans, which let you take out up to 85% of your home's value.
- Finally, folks 62 and over who want to supplement their income should look into reverse mortgages if they don't have the income or credit scores to qualify for lower-cost financing. Otherwise, a cash-out refinance or home equity loan is a cheaper option for cashing out equity.
Get Mortgage Interest Rate Quotes
Once you know what product can help you achieve your refinancing goal, it's time to get some mortgage interest rate quotes. You can call around or get them online. Try to get all mortgage quotes the same day--interest rates change so quickly that mortgage quotes can't realistically be compared from one day to the next. Remember to give all lenders the same information--your rate depends on where your property is, its value, its use (rental, vacation home, or primary residence), and your credit rating. Unlike in the past, today's lenders impose surcharges for higher-risk clients or properties, so you can't get a realistic mortgage quote without providing a lot of information.
Determine Your Refinance Break-even Point
If refinancing to a lower interest rate, feed your quoted rates and loan costs into an online mortgage refinance calculator. or use this worksheet from the Federal Reserve. to determine how long it would take to recoup your refinancing costs. Choose to refinance if your break-even period is reasonable (typically 5 years or less, depending on how long you plan to keep your home). Ask also about no-cost refinancing. If a no-cost refinance is available at a lower rate than you are paying now, refinancing is a no-brainer. If you aren't sure about your future plans, and refinancing costs are very high, you should probably hold off.
Your mortgage is an important component of your financial portfolio. Consider your decision to refinance as carefully as you would any other investment.