Deciding when it is best for you to refinance can be a very difficult decision. The first thing one must decide before even considering whether you should refinance, is why you want to refinance.
Refinancing is the process when a homeowner gets a new mortgage to pay off their previous mortgage. Like a standard mortgage when a homeowner goes to refinance, they need to pay closing costs. However, unlike a standard mortgage the homeowner has more flexibility on when they close, does not have to compete with other buyers, and does not have to move.
You can refinance for many different reasons either you need a lower monthly payment, you want to reduce how much you will pay in interest over time, you want to change your mortgage type, or you want to take some equity out of your home. There is no right or wrong reason to refinance, however, why you want to refinance changes how you will determine when you should refinance.
If you are looking to lower your monthly payment, there are two main situations that will be best to help you achieve that goal. These situations are when interest rates are lower than your current mortgage or if you have built up equity in your home and wish to extend the term. If the interest rates are lower than your original mortgage, and you refinance you will be reducing your monthly interest contribution which will drop your payment amount. However, if interest rates are roughly the same and you have built up equity in your home, you can refinance by remortgaging for the amount you have left to pay over a longer time period. If you are lucky and have both situations at the same time you can extend the length of your mortgage and reduce the rate. The main thing to consider is that if you extend the length of your mortgage, it will increase how much you pay in interest over the length of the mortgage.
For some, reducing how much you pay in interest over the length of the mortgage is more important than lowering your monthly payment. Someone who wishes to reduce the interest over time may get a larger monthly payment that contributes more to the principal and less to interest. These individuals would want to refinance to a shorter loan term, at a lower rate.
Other people just want to change their mortgage type. This is very common with those who get a loan with PMI for the length of the loan or with higher interest rates. For a traditional mortgage, a mortgage needs to have 20% equity for the PMI to be waived and would be the same for when you refinance.
If your goal is to get equity out of your home, you could refinance and cash out some of it out. When refinancing you are normally limited to how much you can take out because you need to maintain 20% equity in the loan. These loans can also have higher interest rates than if you were refinancing the original mortgage for a lower payment or shorter term.. Other options for those who wish to get equity out of their homes are either a Home Equity Line of Credit (HELOC) or Home Equity Loan (HELOAN). These loans are in addition to your mortgage but have different costs and requirements for the loan*.
The last thing you should consider before refinancing is what your breakeven point is. You can find the breakeven point for some by dividing out how much you will spend to refinance vs. how much you will save each month. Here are few examples:
- To refinance your home with a lower interest rate it will cost $7,000 but you will be saving $300 a month by doing so**.
- $7,000 Closing Costs/ $300 Monthly Savings = around 24 Months till breakeven (2 years)**
- To refinance your home to reduce PMI it will cost $6,000 but you will save $146 a month by doing so**.
- $6,000 Closing Costs/ $146 Monthly Savings = around 42 Months till breakeven (3.4 Years)**
- To refinance your home to get equity out. If you mortgage a home 10 years ago for $400,000 for a length of 30 years at an interest rate of 4% and wished to take out $20,000 with closing costs of $6,000 at an interest rate of 4% for 30 years you would not meet a break even point for the length of the loan but the payment would drop by around $300**.
- If instead the interest rate was lower during the refinance by 0.5% the break even point would be around 80 months**.
For loans that increase the length of the loan it is good to use a more in-depth calculator that will give you a better idea on how the interest payments will impact your breakeven point. Test out a few scenarios on what you think might be a good refinance process using our Home Financing Calculator – Should I Refinance***. For more detailed information on what you will qualify for, and potential savings, contact a financial professional.
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*Speak with a financial advisor to get more information on these loan types and loan requirements.
** These numbers are used for illustrative purposes only, and in no way represent what a buyer will pay during closing. Contact a financial advisor for more information.
**The information provided by these calculators is intended for illustrative purposes only and is not intended to purport actual user-defined parameters. The default figures shown are hypothetical and may not be applicable to your individual situation. Be sure to consult a financial professional prior to relying on the results.