When Should You Refinance Your Mortgage?

For many borrowers, it’s best to refinance when you can lower your interest rate and plan to stay in your home long enough to recoup the refinance closing costs.

Bill Packer, chief operating officer of reverse mortgage lender Longbridge Financial, outlines a trio of factors to consider:

• The after-tax monthly savings (new payment compared to old payment, after any tax-favored treatment)
• The amount of time you intend to be in the home
• The cost of obtaining the new mortgage

Once you know these three things, you can calculate your return to see if it’s positive, Packer says.

Example: Deciding when to refinance a mortgage

Let’s say you took out a 30-year mortgage for $320,000 at a fixed interest rate of 6.23 percent. The monthly payment totals $1,966, and over the life of the loan, you’d pay $707,808, which includes $387,808 in interest. Say five years later, rates drop to 5.82 percent. At that point, you’d have $299,842 remaining on the original loan. If you were to refinance to another 30-year loan at that lower rate, your monthly payment would total $1,763 — about a $200 savings. Over the life of the loan, you’d pay $334,893 in interest, saving you $53,000. The amount you can save by refinancing depends on several factors beyond rate, however, including your closing costs and whether you’ve chosen the right kind of refinance for your needs. You won’t begin to realize savings until you reach the breakeven point: when the amount that you save exceeds the closing costs.

Here are the key reasons to consider refinancing:

Lower the interest rate

If mortgage rates have dropped since you first obtained your mortgage, a rate-and-term refinance can provide you with a lower rate (assuming you qualify). Ideally, that rate should be one-half to three-quarters of a percentage point lower than your current rate.You might also qualify for a better interest rate if your credit score has improved since taking out your current loan. The best rates go to those with a score of at least 780.

Shorten the loan term

You can also refinance to shorten the time it takes to repay your loan. If you have a 30-year mortgage, for example, you might want to refinance to a new 15-year mortgage. Ideally, you’d get a lower interest rate and lower monthly payments with the new loan, but it depends on prevailing rates and your remaining loan balance.

Change the rate structure

Along with lowering the rate or shortening the term, some borrowers refinance from an adjustable-rate mortgage (ARM) to a fixed-rate loan. The former gets you out of variable-rate monthly payments and into a fixed monthly payment, which could make it easier to budget for. On the flip side, switching a fixed-rate loan to an ARM might allow for temporarily lower payments until the rate adjusts.

Pay for large expenses

You can do a cash-out refinance to tap your home’s equity for ready money. You can use these funds for any purpose, such as:

• Lowering or paying off high-interest debt
• Renovating your home
• Paying college tuition
• Investing in property
• Eliminate private mortgage insurance (PMI)

If you have a conventional loan and your home’s value has increased, you could refinance to get out of paying private mortgage insurance (PMI) right away, or at least earlier.

When you should not refinance

There are times when refinancing isn’t the best option. Generally, it might not be smart to refinance for any of these reasons:

• You’ll pay a lot more in interest. If prevailing rates are higher than your current rate, or your credit and finances today mean you won’t qualify for a lower rate, it might not make sense to pay more for a new loan.
• You plan to sell your home soon. If you’re selling soon, you’re unlikely to be in the home long enough to recover refinancing costs.
• You plan to use the savings for discretionary spending. Don’t fall into the trap of putting your home on the line to spend the refinance savings or cash-out proceeds on one-time expenses like a vacation or car. In general, it’s better to save for these costs.
• You’re far along in your mortgage. If you’re already at least halfway through the loan term, you might not save money by refinancing. You’ve already reached the point where more of your payment is going to loan principal than interest; refinancing now means you’ll restart the clock and pay more toward interest again.

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