How do you know when to refinance your mortgage? Many people know that refinancing a home loan could save them money, but it isn’t always true that you’ll come out ahead with a refinance. Your potential savings depends on your circumstances, the terms of the old loan and the terms of the new refinance loan.
The Break-Even Point
While there are many factors to consider when deciding if now is the right time to refinance, the biggest of these is the break-even point of a mortgage loan. This is the point in your repayment plan when you begin to realize savings on your mortgage. If you are considering refinancing, you may have several break-even points to calculate to know if you’ll be saving money.
First, consider your current mortgage. Did you purchase discount points upfront to save on your mortgage payment and interest rate? If so, you could lose out on potential savings if you refinance too early. Say you paid $4,000 for two discount points to lower your monthly payment by $57. It would take about 70 months, or almost six years, to realize the savings for that investment. If you refinance or sell before that 70-month break-even point, you could lose out on those savings.
Next, consider the refinance mortgage you’re contemplating. What will be the closing costs of the new loan? A recent closing cost survey found the origination and third-party fees, which typically include a new appraisal, title search and application fees, can cost an average of about $2,084 on a $200,000 mortgage. Say you could save $70 per month by refinancing such a loan. It would take 30 months, or 2.5 years, to break even. So you wouldn’t want to sell or refinance in another 18 months, because you would lose out on those savings.
There are several ways to calculate your own mortgage’s break-even point. The most basic formula is your total closing costs divided by your monthly savings, which will give you the number of months needed to break even. For discount points, it’s the total cost of the points divided by your monthly savings. However, there are more complex mortgage refinance break-even calculators available for free online, some of which take into account appraised home value, loan terms and more.
The Situations When It Makes Sense to Refinance
Beyond the break-even point of your home loan, there are a number of situations when it usually makes sense to refinance. This has to do with the potential to save more money on your monthly payments, save on interest over the life of the loan or better adapt your loan to new financial circumstances.
A High Interest Rate
One of the most common situations where a refinance makes sense is when your own loan’s interest rate is significantly higher than currently available rates. Historically, experts have advocated refinancing when you could reduce your interest rate by at least 2.0 percentage points. However, some experts now say a difference of 1.0 percentage points could be enough of an incentive to refinance.
A Variable Interest Rate
Another very popular reason for refinancing is to switch from an adjustable-rate mortgage (ARM) to a more traditional fixed-rate mortgage. ARMs usually offer a low fixed-rate introductory period, but then adjust according to the market rate after months or years. This can leave you with an interest rate that is higher than you would otherwise have with a fixed-rate loan, and a good incentive to refinance for a better fixed rate.
A Shortened Loan Term
Should interest rates fall, or you advance in your career to a much higher income level, it may make sense to refinance to shorten your loan’s repayment term. In a market where interest rates are falling, you may be able to refinance from a 30-year to a 15-year mortgage without too much change in your monthly payments. But even when rates are steady, shortening your mortgage term could save you tens of thousands in interest over the life of the loan, if you can afford a higher payment.
A Change of Income
It may be a good idea to refinance if you suddenly find you are making a lot more money. However, it could also be a good time to refinance if you anticipate a lower income. This is especially true for homeowners approaching retirement. If you are nearing retirement and still have several years left on your mortgage, you may benefit from a lower rate and payment that will better match your reduced income during retirement.
A Change of Credit
Another consideration is your credit score. If you had an average or even fair credit score when you purchased your home that has since improved to good or even excellent credit status, you might look into refinancing. Credit score has a lot to do with the mortgage rate you qualify for, and a significantly higher score could mean you could now save on both monthly payments and long-term interest.
An FHA Loan with PMI
Another situation where refinancing makes sense is when you have a Federal Housing Administration (FHA) loan with private mortgage insurance (PMI). PMI is an added expense every month for those with an FHA mortgage. Unlike other loans, where PMI is canceled after the homeowner reaches 22% equity, FHA loan PMI remains for the life of the loan. Moreover, the PMI rate of an FHA loan is usually higher than that of other loans which require mortgage insurance. If you’ve met the break-even point in your FHA loan, it often makes sense to refinance to save on or cancel your PMI.
It’s not always easy to know when to refinance your mortgage. A lot depends on your current circumstances and the refinance loan you’re considering. While it’s possible to save thousands on a mortgage with a refinance, it’s crucial to know the break-even point of your current loan and potential future loan. If you will sell or refinance again before you break even, it may be better to stick with your current mortgage. On the other hand, there are a number of situations where refinancing could save you thousands over the life of your loan while also saving you money on your monthly mortgage expenses.