You hear that interest rates dropped and you instantly think you should refinance. Is it the right choice, though?
Unfortunately, it’s not always a good option. While refinancing can definitely be a good way to save money sometimes, you have to weigh many factors before you decide if it’s right for you. Refinancing costs money and it resets your term (if you keep the same term). After a while, you could just be sending yourself in circles without making any headway on your home’s equity.
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So how do you decide when it’s right to refinance? We take a look below.
Can you Lower Your Payment?
The largest reason many borrowers refinance is to get a lower mortgage payment. It certainly seems to be a good enough reason. But, before you do it, make sure you figure out your break-even point. This is the point where you actually start reaping the savings after you pay off the closing costs.
Here’s how you figure out your break-even point:
- Total up
your closing costs. Let’s say your new loan would cost you $5,000 in closing costs.
- Figure out your monthly savings with the new, lower payment. Let’s say you would save $150 per month.
- Divide the total closing costs by the monthly savings. In this case, it would take 33 1/3 months or 34 months to break even.
You can then use that break-even point to determine if it makes sense to refinance. For example, if you know you will move after 48 months, it doesn’t make much sense to change loans. You will only realize the savings for 12 months, making the extra $5,000 unnecessary.
If, on the other hand, you will stay in the home for the next 10 years, it may just make sense as you have plenty of time to enjoy the savings.
Can you Shorten the Term?
Are you trying to own your home faster? In other words, are you trying to pay the loan off faster? Refinancing into a shorter term can help you reach your goal. If interest rates drop and you have
the debt ratio that allows you to secure a 15 or 20-year term, it would be a great time to do it. Just make sure that your income is stable and that you can comfortably make the higher payment for the remainder of the term.
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If you are unsure, refinancing isn’t necessary. You can calculate the 15-year term payment on your own and just make extra payments towards the principal while keeping the 30-year term in case you cannot pay extra one month. The only downside to this method is you keep the higher interest rate. Shorter terms usually have lower interest rates, so if you can swing it, you might want to make the switch.
Can you Reduce the Loan’s Risk?
If you took out an adjustable rate loan when you bought the home, you might be reconsidering that decision when the rate starts adjusting. This could be a good time to consider a refinance.
Just when it makes sense to make the switch depends on the market and your rate at the time. If your rate adjusted and it’s fairly high, you may feel desperate to get out of it and take any interest rate that’s available. Make sure that you make a rational decision though so that you make the right choice. Since refinancing costs money, you don’t want to do it more than once, so make your decision wisely.
You can even refinance out of a
fixed rate into an ARM, but unless you have extenuating circumstances, that’s not always the best idea. The only time it might make sense is if you know you are going to move in the next few years. If interest rates drop dramatically and you can get a really low rate with an ARM, you can make the switch, but again, make sure the break-even point makes the switch worth it.
Taking Cash out of the Home Isn’t Always a Reason to Refinance
Many people equate refinancing with tapping into the home’s equity. Yes, this is a possibility, but it’s not one of the best reasons to do so. If you need money to fix up your home, it may make sense to use the money tied up in the home since it will help increase the home’s value and help you get your LTV down. If you need the money for other reasons, though, you may want to exhaust all other options before touching the investment in your home.
You will pay interest on the money you borrow for the
term of the loan, which is usually between 15 and 30 years – that’s a lot of interest. Make sure you cannot secure a home equity line of credit or even a credit card with a high balance before you touch your home’s equity with a refinance.
If you want to refinance, weigh the pros and cons with your lender. In other words, see what options you have so that you can make sure you choose the option that saves you the most money not only know, but throughout the term of the loan as well.
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