Is Refinancing My Mortgage a Good Idea?

Is now a good time to refinance your mortgage? Will a lower interest rate cover the closing costs within a desired period? The decision to refinance your home depends on many factors. In some cases, refinancing is a wise decision. In others, it can cost you money.

Because you already own the property, refinancing is often easier than obtaining an initial loan for a property. Additionally, if you have owned your property or house for a long time, you may have built up significant equity, which will make refinancing easier.

The typical rule of thumb is that if you can reduce your current interest rate by 0.75% to 1% or higher, it might make sense to refinance. However, there are costs involved. Refinancing costs are almost as high as the cost of an initial mortgage. Your outlay will have to cover closing costs, title insurance, attorney’s fees, an appraisal, taxes, and transfer fees.

Closing costs will vary according to your interest rate. For a lower rate, your closing costs will be relatively high. For a higher rate, your closing costs will be less.

The first step in your decision to refinance is to calculate your monthly savings once your refinancing is complete.

For example, suppose you have a 30-year mortgage loan for $200,000. When you first assumed the loan, your interest rate was fixed at 6.5% and your beginning of month payment was $1,257. If interest rates are now are 5.5% fixed, this could reduce your monthly payment to $1,130. This would be a monthly savings of $127, or $1,524 annually.

Your lender can calculate your total closing costs for the refinance should you decide to proceed. If your costs amount to approximately $2,300, you know that your break-even point would be 1.5 years in the home ($2,300 divided by $1,524 = 1.5 years).

In this scenario, if you plan to stay in the home for two years or longer, refinancing makes sense.

During periods when home values decline, many homes are appraised for much less than they have been appraised historically. If this is the case when you are considering refinancing, the amount at which your home is valued may mean that you lack sufficient equity to satisfy a 20% down payment on the new mortgage. To refinance, you will be required to provide a larger cash deposit than expected, or you may have to carry private mortgage insurance (PMI), which will ultimately increase your monthly payment. in this case, even with a drop in interest rates, your real savings may not amount to much.

Most of the time, a refinance that will remove your PMI will save you money and is worth doing for that reason alone. If your house has more than 20% equity, you will not need to pay PMI, unless you have an FHA mortgage loan or are considered a high-risk borrower. If you pay PMI, have at least 20% equity, and your current lender will not remove it, you should refinance.

(For more, see "6 Questions to Ask Before You Refinance" and "Mortgages: The ABCs of Refinancing.")