When to Refinance Your Mortgage

Refinancing is the process of paying off an existing mortgage loan with a new one. Generally speaking, if refinancing can save you money, help you build equity, and pay off your mortgage more quickly, it’s an intelligent decision. That said, other scenarios also provide homeowners with a distinct opportunity to refinance, with the most common outlined below.

Refinancing to lower your interest rate

Depending on who you talk to, you’re likely to get varying answers regarding the ideal time to refinance your mortgage. However, a good rule of thumb is to consider refinancing when the current interest rate is approximately one percent below your current rate.

Reducing your rate will not only help you save money but also increase how quickly you build equity in your home.

While every situation is different, what matters most is how quickly you can recoup your closing costs (which can run between 2 and 5% of the loan’s principal) and other fees (appraisal, title search, etc.) compared to how long you’ll have the mortgage.

For example, if refinancing would shave $100 off your monthly payment but set you back $4,000 in closing costs, it would take 40 months for the monthly savings to catch up to your investment. In this case, refinancing is perhaps only worthwhile if you plan on staying in your home longer than 40 months.

Use the same math if your credit score has improved (typically 20-40 points since obtaining your last mortgage) and you thus want to learn if you qualify for a lower rate. The same applies if you’re converting to—or, more commonly, from—an adjustable-rate mortgage (ARM).

Refinancing to cash out

A cash-out refinance takes your existing mortgage balance and converts a portion of your current equity into cash (a loan), combining both into one larger mortgage. Homeowners often utilize this strategy when they need a lump sum of money to pay for home improvements or college, consolidate high-interest debt, or purchase a second home.

While a cash-out refinance is perhaps a good idea for your situation, only rely on this strategy if you’re a financially disciplined homeowner: as your new mortgage may not only extend how long you’re in debt but also increase the interest you’ll pay over the life of the loan.

What’s more, you could end up underwater (i.e., if home values drop, you may owe more than your home is worth). For some, this is a step closer to a never-ending debt cycle. Depending on your own unique needs, consider alternatives such as a home equity loan, line of credit, or personal loan—each comes with zero or few closing costs.

Refinancing for a shorter term

Reducing the term of your mortgage helps you save on interest and pay off your home more quickly, but it can include substantially higher payments. You’ll therefore need to ensure these larger payments fit into your existing budget. As with the other scenarios we outlined, you’ll need to know how quickly you’ll recoup closing costs. Keep in mind alternatives designed to pay off your mortgage more quickly in the absence of refinancing costs do exist, including allocating more toward the principal each month or relying on a biweekly mortgage payment schedule.

Mortgage refinancing concepts to know

Amortization
Regardless of the circumstances, it’s important to familiarize yourself with a few distinct concepts. The first is amortization: the period in which debt is reduced or paid off.

When you refinance, the process restarts the amortization period. Let’s say you are three years into a 20-year loan, and your new loan is also for 20 years; in this case, you’ll make payments over a 23-year period. In this scenario, it might make sense to refinance to a shorter term or preserve the same term and prepay the mortgage with savings to repay more quickly (at least until you “catch up”). You can enlist the help of an amortization schedule calculator to determine which option makes the most sense for you.

Loan-to-value ratio (LTV)
Expressed as a percentage, your loan-to-value ratio (LTV) is the size of your loan compared to the value of the asset you are borrowing against (your home, in this case). Lenders use this ratio to determine loan risk; the higher the LTV, the more risk a lender assumes (which often means higher costs for you, the borrower, assuming you qualify).

To calculate LTV, divide your mortgage balance by your home’s appraised value. Let’s say your home is appraised at $400,000 and your mortgage balance is $200,000; in this case, your LTV is 50 percent. If your lender only allows up to an 80 percent LTV (anything over 80 percent often requires the borrower to pay for private mortgage insurance), you can cash out an additional $120,000.

Private mortgage insurance (PMI)
When you refinance, you should know how much equity you have in your home—meaning the difference between its market value and what you owe—because anything less than 20% means lenders will typically require private mortgage insurance (PMI). This insurance provides the lender with extra protection in the event you default; and it isn’t cheap, costing between .5% to 1% of your loan amount. To gain an idea of market value, you can check your area’s property values and/or consult with a local real estate agent.

The bottom line: refinancing your mortgage

In sum, it’s simply not easy to make a broad case for mortgage refinancing as it all depends on your own unique situation. Generally speaking, if refinancing can help you save you money, build equity, and/or pay off your mortgage more quickly, it’s an intelligent decision to make. When used carefully, it’s also a valuable tool for consolidating debt or purchasing a second home.

Hopefully, after reading this post, you feel more prepared to consider such a move than you did previously.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.