Should You Refinance Your Mortgage?

March 30th, 2016

Mortgage interest rates are at historically low levels, leaving many people to wonder if they should refinance their mortgage. But someone shouldn't refinance based solely on interest rates. Like any major financial decision, it has both pros and cons.

What exactly does refinancing your mortgage involve? Refinancing your mortgage means that you end your original mortgage and then take out a new one. Since it’s a brand new mortgage, you'll be able to get a new interest rate and set different terms like the length of the loan.

You can also choose whether or not you want an adjustable-rate mortgage (ARM) or a fixed rate mortgage. A fixed rate loan will have the same interest rate for your entire mortgage. An ARM's interest rate can change from year to year.

Here are a few things you should consider when deciding whether to refinance or not:

Closing costs

There is a general rule of thumb that you should refinance your mortgage if your interest rate will decrease by 1 percent or more.

However, you have to pay closing costs when you refinance your mortgage, which can cost thousands of dollars. The overall fees usually amount to about two to five percent of the cost of your house.

Think about how much your closing fees will be, and how long it will take you to repay them before refinancing.

These closing costs can include fees for:

Cost of mortgage payment

Possibly the biggest reason people refinance their loan when interest rates are low is to lower their monthly mortgage payments.

When trying to lower the cost of your mortgage payments through refinancing, think about how much your overall loan is. A one percent interest rate reduction will matter much more if you have a $600,000 loan than if you have a $200,000 loan.

And you'll need to factor in other considerations such as closing costs and how long you plan on staying in your house.

How long you're planning to own the house

When thinking about refinancing, how long you plan on staying in your house is one of the most important factors to consider. If you plan on leaving your house sooner than later, refinancing might not be a great idea.

To figure out if it makes sense, you should calculate your break-even point. Just like it sounds, this will tell you at what point you will break even between your closing costs and the amount of money you save with your lower mortgage payments.

There are several break-even calculators available for free online. A simple way to figure this out, though, is to take your refinance costs and divide it by your savings per month. This will tell you how many months it will take until you break even.

If you plan to move before the break-even point, you shouldn't refinance your mortgage.

Length of your mortgage

One reason to refinance your mortgage is to get a shorter term loan. For instance, you may currently have a 30-year mortgage, but if you refinance you can get a new mortgage with a 15-year term.

A shorter term mortgage means less interest, and ultimately is less costly. Keep in mind though, that you'll have larger mortgage payments each month.

Your credit score

Another reason to refinance your loan is if your credit score has improved since you obtained your last mortgage. As you’d expect, a person with a high credit score will typically get a lower interest rate than someone with a low credit score, other things being equal. If you have a score of 740 or more you are generally eligible for the best mortgage rates.

Keep in mind that if your credit score is lower than 620 it may be difficult for you to get a home loan at all.