If you think refinancing your mortgage is as simple as finding a lower interest rate, you may be wasting your money.
While saving on interest is definitely a part of the equation for refinancing, there’s a lot more to consider and some of factors may even surprise you.
Here are some situations to think about where refinancing your mortgage often makes sense.
Valuable savings with rate changes
The main goal for many homeowners seeking to refinance is to lower the interest rate, saving on interest costs. For many, 2012 has been a great year to do that with historically-low interest rates available. Of course, it all depends on your current rate to see if you’re getting a good deal as well as changes to the terms of your mortgage.
Calculating the savings and other benefits may depend on your goals, but a good place to start is to look at the total cost of refinancing versus keeping your current loan. Since refinancing often changes the length of the loan term, your expected interest payments will adjust during both the repayment period and new interest rate.
To see how refinancing will save or cost you money in your specific case, make sure to compare the total costs of what you’re being offered and your current loan. You can use a refinance calculator that will calculate interest savings or costs. You may be surprised to find you’re paying more over the long-term instead of saving money. No matter how you calculate the new costs, be sure to compare to your current loan before signing on the new loan.
Matches long-term plans
You should also consider how long it will take to just break even on savings from reduced monthly payments compared to closing costs, especially if you’re considering a move. Due to closing costs, it will take months or longer to see the savings from refinancing.
Luckily, this calculation is an easy one. Just divide your total closing costs by the savings on your monthly payment. For example, if you’re paying $3,000 in closing costs to save $200 a month, you’ll have to stay in your home for 15 months before this deal makes financial sense.
Security with a fixed-rate loan
A common reason for refinancing in any climate is to not only reduce the cost of a mortgage, but also secure a permanently lower interest rate. While adjustable rate mortgages (ARMs) may work great in certain circumstances, there’s always the uncertainty and risk with loans that could have increasing interest rates later.
When interest rates are low, like they are right now, interest rate differences between ARMs and fixed-rate mortgages may not be all that different. Currently, a fixed-rate 30 year mortgage comes in at about 3.6%, with a 5/1 ARM at 2.7%, less than one percentage point difference between the two. Locking in the fixed rate may be worth it later as interest rates are likely to eventually increase.
Affordable closing costs without using important funds
According to Bankrate.com, the average closing costs are about $3,700. Coming up with the money to refinance may be challenging for cash-strapped homeowners.
No matter how desperate you may be to refinance, make sure you’re not putting stress on your savings. The cash you’ve saved is important for anything from small emergencies all the way up to a cushion should you lose your job. Depleting these funds to cover a refinance can exposes you to serious risk.
If you don’t have the cash on hand for closing costs, you may not be completely out of luck. Amy Slotnick, Vice President at Fairway Independent Mortgage in Needham, Massachusetts explains that it is possible to avoid paying closing costs and points. “You should inquire as to whether the lender has a no points and no closing costs option that makes sense,” she says. But it’s not all good news, as she explains, “Over the long term, it often makes sense to pay the closing costs out of pocket or to roll them into the loan amount rather than paying the higher ‘no costs’ rate.”
If you’re looking to save money in the long-term, paying a higher rate instead of the closing costs might actually cost you more. Since this option doesn’t maximize savings, make sure to examine your goals. Is there a valuable trade-off for not obtaining the lowest interest rate, like monthly savings that can be used to fund other goals? Ask these questions first before potentially costing yourself more money.
To take out cash for important goals
Depending on your goals, saving on interest might not be top priority. Refinancing can provide cash to pay for other important reasons, like helping to fund a college education, making home repairs, or paying down more costly debt.
Ms. Slotnick advises that with interest rates so low, now might be the best time, if ever, to borrow against the equity of your house to meet other financial goals.
“Many people have equity in their home that they could use to meet other financial objectives,” she says. “With interest rates this low, the cost of borrowing is more affordable than ever — at a rate of 3.5%, each $10,000 borrowed is a $45 monthly payment.”
While your home might be an easy way to take out extra cash, this money isn’t free and should be slated for specific and important purposes like the ones mentioned above. While rates like 3.5% might sound like a deal, interest still adds up, especially over a 30-year term.
Borrowing against the equity in your home can be a risky move, too, as seen with the rise in mortgage foreclosures in the past several years when homeowners put their houses on the line to borrow money. Slotnick advises that you should seek advice from a financial planner before making a decision like this one.