Every time you hear interest rates dropped, you might consider refinancing. Did you now that refinancing your current mortgage is not always worth it, though? There are certain situations when it does not make sense. It has to do with more than just the interest rate. We will discuss the considerations you should make before you refinance to make sure it is worth it.
Type of Refinance
First, you need to determine the type of refinance you need. There are two types:
- Rate/term
- Cash-out
A rate/term refinance occurs when you want to lower your interest rate or change the term of your loan. You do not touch the equity in your home. The primary focus is to save money every month or to pay the loan off faster with a shorter term.
A cash-out refinance may have a higher interest rate than you currently have, but it gives you access to the cash you accumulated in the home. Whether you paid the principal balance down, the value increased or both, you have money in the home that is yours.
When Does a Rate/Term Refinance Make Sense?
If you have a high-interest rate right now, it might make sense to refinance into today’s lower rates. However, you have to take into account the closing costs you have to pay. The general rule is you should be able to pay your closing costs off in 3 years. This means you save enough each month with the new mortgage payment to pay the closing costs off in 36 months. If it takes longer than that, it might not be worth it.
On the other hand, if you wish to shorten the term of your loan, refinancing your current mortgage might not make sense. Again, you have to figure in the closing costs. If your closing costs are 1.5-2% of your loan amount, you move backward rather than forward on your principal balance. If you wish to shorten the term, you don’t have to make it official – simply make extra payments each month or as often as you can. You automatically shorten the term without it costing you a dime.
When Does a Cash-Out Refinance Make Sense?
You can use a cash-out refinance for a variety of purposes. Many people use it to consolidate their debt, whether their credit cards or a second mortgage. Whether or not it makes sense depends on the circumstances of your loan. Will the new payment be lower than the individual payments combined? Is the interest rate lower than what you were paying? These are things you need to consider because you extend the time it takes to pay off these debts. A credit card debt might have taken you 5 years to pay off, but if you wrap it into your mortgage, it could take up to 30 years now. If the interest is lower, though, it could make sense.
You can also use a cash-out refinance to pay for large ticket items, such as household appliances, a vacation, or a wedding. Many homeowners also use it to help fund home remodeling or repairs. If you don’t have any other method to obtain the funds and the interest rate is low enough, it can make sense. If, however, you will exceed an 80% LTV, which many programs won’t allow, you have to figure in the PMI you have to pay for the higher LTV.
The bottom line with a cash-out refinance is whether you can afford the closing costs and the higher payment. You can work through various scenarios with several lenders to see which program offers you the most affordable payment along with the lowest costs.
Refinancing Your Current Mortgage if it’s an ARM
If you have an ARM or adjustable rate mortgage, you might want to refinance before the rate adjusts. You likely have a 3 or 5-year fixed period and then the rate can adjust annually. There is no way to predict how much it will change with the exception of the caps noted in your closing documents. There is a maximum your interest rate can hit, but it is generally pretty high. If you plan to stay in your home for at least 3 years after the rate is set to adults, it makes sense to refinance your mortgage.
On the flip side, if you have a fixed rate and know you will move in the next 3 years, you can refinance into an adjustable rate loan. This gives you the chance to save some money over the next few years. Since you will move before the rate adjusts, you do not have to worry about any rate adjustments.
Refinancing Your Current Mortgage is a Personal Decision
There is no cut and dry answer regarding whether refinancing your current mortgage is right or not. You have to crunch the numbers and think of the future. If you don’t know where you will be in 3-5 years, assume you will move to determine the right choice. This way you can always change your mind in the future if you decide to stay, but have the protection of the lower rates as if you were moving. Talk to various lenders to see what options you have, including the amount of closing costs you pay and the interest rates you are able to obtain. Shopping with 3 or more lenders is the best way to make sure you receive the best deal available.
