If you own a home and have a mortgage, like me, you probably get [practically daily] offers in the mail to refinance at a lower rate. And while some of these offers might seem too good to be true, it can actually save you a lot of money… and right now might actually be the best time to do so. But that isn’t the case for everyone.
So how do you know if refinancing is the right thing for you? In this guide, we’ll show you how to calculate your potential savings and compare that to costs to determine whether it’s the right move for you.
Qualifying: Credit score, income, and debt
For many homeowners, refinancing is the same process as taking out a mortgage. Credit check, income verification, income to debt analysis, the whole works. And if your financial situation has taken a hit you may not even qualify for refinancing.
Beyond that, a financial background check may determine whether or not you qualify for the lowest interest rates or preferable terms for the new loan. Having a poor credit score or too much debt can be the deciding factor for whether or not refinancing your mortgage is worth it.
But that doesn’t mean those with bad credit can’t benefit from refinancing. For those first-time homeowners who’s mortgages are insured by the FHA, their streamlined financing program, for example, doesn’t require many of these financial background checks and instead looks at the payment history for your current mortgage. So even if you’ve found yourself in financial trouble, if you pay your mortgage on time each month, you may still qualify.
When you’re deciding whether to move forward with refinancing, the first thing you’ll want to do is calculate the potential savings of the new interest rate. I’ll use a simplified example so you can see how much it can potentially be:
Amount left on mortgage: $150,000
Current interest rate: 5%
Time remaining: 25 years (300 months)
New interest rate: 2.6%
Time remaining: 25 years
So, with these numbers we can calculate both the amount of interest you will pay under each as well as your monthly payments so you can compare the two. For these calculations, I used zillow.com’s refinance calculator (and ignored the fees…for now):
In this scenario, by refinancing, you would save $190/month in mortgage payments and over $57,000 in interest over the life of the loan. Not only that, but if we used that monthly savings to pay down additional principal each month, the overall interest savings would be even better.
Seems like a slam dunk…but…
Closing costs & refinancing fees
When you purchase a home, there are a number of fees that you must pay. These fees are called “closing costs”, and they definitely add up. Many of these closing costs are directly related to the financing of the home, and as you might have guessed: refinancing isn’t free. In fact, refinancing isn’t all that much different of a process from the original closing, so it also includes many (if not most) of these costs which you will have to pay (again).
The most difficult part is calculating these costs before you get to closing. And in order to get an accurate picture of your potential net savings, you must get an accurate picture of all costs.
Another great refinancing calculator by smartmoney.com includes a more comprehensive itemized list for these costs (which can then compare it to your savings). Closing costs for refinancing generally can include:
The ‘Other’ field suggests, too, that even this list is incomplete. Before you decide to go through with refinancing, make sure you know and understand all the fees and costs that you will be responsible for.
For some perspective, according to Bankrate.com, the average closing costs (loan origination and title fees) were $3,100 for a $200,000 mortgage. This doesn’t include taxes, insurance, or other pre-paid items such as prorated interest or homeowner association fees.
Savings vs. Costs – how long will you be in your home?
Once you’ve figured out how much you will save as well as how much it will cost you to refinance, you can then determine if doing so will be beneficial to your overall financial situation. What it comes down to is how long before the interest savings catches up to the closing costs. In other words: how long (after refinancing) do you need to stay in your home before you break even, and then start seeing net savings?
Continuing our above example, let’s say that closing costs for refinancing cost an even $4000. Since our monthly savings is $190, we can determine how many months before we recoup the initial fees:
$4000/$190 = 21 months
So, in this scenario, as long as we planned on staying in this home for another 2 years, refinancing would make financial sense.
FHA Streamlined refinancing
Beyond extremely low interest rates, one of the reasons it’s a great time to refinance is that for FHA insured mortgages, there are options for even further savings on closing costs. The FHA streamlined refinancing program, was designed to reduce closing costs by getting rid of a number of the requirements, like home appraisals, saving money on a number of otherwise unavoidable fees. Also, by not requiring things like credit checks or income/debt analyses, more FHA backed borrowers would qualify for refinancing.
Even more recently, as of June 11, 2012, those that had their mortgages backed by FHA before March of 2009, stand to save even more through reduced FHA insurance fees on the loan. This program, however requires that borrowers refinance through their current lender via the streamlined financing program.
Other ways to save on refinancing closing costs
There are a few options for those who are looking to refinance their mortgage to cover, or at least reduce, potential closing costs.
For those not eligible for FHA’s streamlined programs, closing costs may be rolled into the principal of the loan. Another option (when that available) might be to forgo closing costs in exchange for paying an increased interest rate (though this is usually the least cost effective option). Both of these options will increase the overall cost of closing fees compared to paying for it up-front, and aren’t available for FHA streamlined refinancing.
Here are some ways to potentially reduce closing costs (courtesy of moneycrashers.com):
- If you need an appraisal and your home has significantly risen in value or there are many comparable sales in your neighborhood, ask your real estate agent if you can use an automated appraisal instead of a full appraisal. This will save a few hundred dollars.
- Though you will still need title insurance, ask if you can get the “reissue” rate instead of the full rate.
- See if your current lender can offer you a lower-interest refinance before you sign docs with a new lender. They may be able to get you a reasonable deal without as many costs.