Refinancing your mortgage might seem like a great idea, especially if you can get a lower rate. But, before you do it, consider the following factors. Understanding the full implication of a refinance will help you make the better decision.
Is it Worth It?
The most important question to ask yourself is whether or not the refinance is worth it. In other words, what is your break-even point? This is when you start reaping the savings after taking into consideration the closing costs.
There’s no rule regarding what a ‘good’ break-even point should be. Everyone has their own circumstances. In general, though, 3 years or less is considered good. Of course, this wouldn’t apply to you if you think you’ll move or refinance again within the next 3 years.
You can figure out your break-even point by totaling up the closing costs for the loan and dividing them by the monthly savings you’ll reap with the refinance.
You’ll save $100 per month and the new loan will cost you $5, 0000:
$5,000/$100 = 50 months
The refinance would only make sense if you kept the current mortgage for more than 50 months.
What Term Should You Take?
It’s probably a natural reflex to take a 30-year mortgage even when you refinance. You get the lowest payment, so it might seem to make sense. Before you do, consider your options, though. First, think about how long you’ve held your current mortgage. Have you paid several years down on it? Do you really want to add those years back onto the loan?
Let’s say you had a 30-year mortgage and already paid 8 years on it. If you refinance into a new 30-year loan, you lost the 8 years you already paid on the mortgage. Rather than automatically taking the 30-year, inquire about a 20 and 15-year mortgage. If you can afford the slightly higher payment, you’ll pay the loan off in a similar amount of time while paying less interest.
Make sure you ask any lender you apply with about the various terms available to you. Each lender will have different interest rates, so make sure to evaluate each one.
Should you Pay Points?
If the reason behind your refinance is to lower your payment, you might think paying discount points is worth it. You get a lower rate and a lower payment, what’s not to love? Again, it comes down to the break-even point. If you won’t be in the home or have the same mortgage before the break-even point, it’s not worth paying the extra points.
So how do you know what the break-even point is? Start with the cost of the discount points. Let’s say a lender will charge you 1 point for a 0.5% lower rate and you have a $200,000 loan. The lower rate would save you $50 per month. You’d do the following to figure out your break-even point:
$2,000/$50 = 40 months
It would make sense for you to pay the point only if you think you’ll be in the home and/or have the same mortgage for at least the next 40 months.
Should You Take a Fixed Rate or ARM?
Again, because you are probably refinancing in order to get a lower payment, an ARM may sound like a good choice. The teaser rate they provide can be rather enticing. You get a lower rate and lower payment. But, what happens after the teaser rate? Are you right back at square one?
Before you take the ARM, ask the lender what the worst-case scenario would be in the future. In other words, how high can the rate adjust? You want to know the cost of that payment. You can then compare it to your current payment. Are you really saving money once the rate adjusts?
If you won’t be saving much money or worse yet, it will cost you more once the rate adjusts. You may be better off taking the slightly higher interest rate on the fixed rate loan.
Refinancing always sounds like a good idea, but you must consider how it will affect your specific situation. Taking a higher interest rate or extending your term won’t work in your favor. You’ll end up paying more interest in the long run. Make sure you know all of the details on the loan and that you calculate your break-even point before you decide if refinancing is right for you.