Sometimes refinancing costs you more than you expect.
According to NerdWallet, Americans lose at least $13 billion a year by not refinancing their residential mortgages. While it's true the process can save you a lot of money, it can also be a poor financial decision. Here's a brief explanation of how to determine whether or not refinancing your mortgage is a good idea:
How refinancing works
Refinancing is essentially a way of replacing your old mortgage with one that has different terms. The lender that grants you the new mortgage (whether it's the same as your original lender or a new one) pays off and replaces your old one. Because you already own the property securing the loan, this process my be easier than obtaining your mortgage the first time around.
There are a wide variety of reasons to refinance your mortgage, including:
- The chance to get a lower interest rate.
- The opportunity to switch mortgage types.
- The opportunity to access the home's equity.
- To consolidate debt.
- To shorten the length of the mortgage.
Many people refinance their mortgage to get a better interest rate.
What to consider when refinancing
When deciding to refinance your mortgage, you need to consider several factors:
Interest rates and closing costs
A lower interest rate is enough reason to refinance your mortgage. Investopedia noted that historically, refinancing a mortgage was a good move if the new interest rate was at least 2 percent lower than the original. Now, lenders say that a 1 percent reduction is enough justification to refinance. However, it's worth considering whether the savings incurred are enough to offset the new closing costs and other payments.
Many banks advertise "no-cost" mortgages, but refinancing always comes with certain payments, no matter what. In fact, you'll have close to the same number of costs as you did with your original mortgage, including:
- Closing costs.
- Attorney's fees.
- Title insurance.
- Transfer fees.
The closing costs will be a major factor in your calculations, and they'll change according to your new interest rate. Generally, the higher your interest rate, the lower your closing costs. Alternatively, you can have your closing costs added onto your mortgage, so you pay nothing up front. However, this does mean you'll pay additional interest over time.
Alternatively, a lower interest rate results in higher closing costs. This latter option is generally the best move, assuming you have the money to pay such fees on hand. If you don't have the money but plan to stay in your home for several years to come, have the closing costs added to your mortgage instead of accepting a higher interest rate.
Moving plans and your break-even point
The break-even point is the time at which the savings you've incurred offset the initial cost of refinancing your mortgage. If, for example, your closings costs totaled $2,500 and your new mortgage saves you $125 per month, it will take just under two years for you to break even. If you plan to move before that time, refinancing isn't a good idea.
A lower rate can reduce your mortgage interest deduction, but most homeowners find the overall savings more favorable in the long run.
Your credit score and debt-to-income ratio
Improvements to your credit score could qualify you for a lower interest rate, so check your credit report before starting the process. Also, keep in mind that the amount of debt you have can also affect your rate. If your income has fallen or your debt has increased, your lender may not give you a lower rate despite your good credit.
Deciding to refinance your mortgage sounds like a money-saving idea, but the true benefits depend on your financial situation, the state of the market and your future plans.