Should You Refinance Your Mortgage When Interest Rates Rise?

It's not a bad idea to consider refinancing your mortgage when interest rates are low. And they still are, historically speaking. However, interest rates have started rising and are predicted to continue to do so. How should that affect your decision to refinance?

That, of course, depends on the interest rate you are currently paying on your mortgage. An older mortgage could still have a higher interest rate than those currently offered. And even in a relatively low-interest climate, there are pros and cons to refinancing a mortgage. For example, your improved credit rating or a decision to change the length of your mortgage could also bring refinance terms that could save you money in the long run. But maybe you're not planning to stay for the long run. There are also some special refinancing programs that can be particularly beneficial for those who qualify. Here's how to work through the decision-making process.

In the past, low interest rates have created a refinancing frenzy in the marketplace. But in any economy, the only way to know if a refinance makes sense for you is to consider the details of your unique situation.

How much lower are rates than the one you currently have? Instead of listening to "rules" about how much of a percentage change in interest rates you should look for before you refinance, look at how much money you'll stand to save. A 1% rate reduction is a lot more meaningful if you have a $500,000 mortgage than if you have one that's $100,000.

How long do you plan to keep the mortgage? Just as when you purchased your home, you will have to pay closing costs on your refinance. If you're planning on selling your house in a few years, you may barely break even (or actually come out behind) by refinancing. How come? If the monthly savings for the remainder of your mortgage are not greater than the closing costs associated with the refinancing, you'll lose out. If you roll the closing costs into your mortgage instead of paying them up front, you're paying interest on them, so you'll need to factor this expense into your break-even calculation.

Can you refinance into a shorter term? If you have 20 years left on your mortgage and you refinance into a new 30-year mortgage, you may not save money over the long run, even with a lower rate. However, if you can afford to refinance that 20-year mortgage into a 15-year mortgage, the combination of a lower interest rate and a shorter term will substantially reduce the total amount of interest you'll pay before you own the house free and clear.

Done properly, a refinance can have both immediate and lasting benefits. You may be able to:

Get a better loan. Perhaps you are in a better financial position now than when you took out your existing mortgage. Refinancing may provide an opportunity to get a better interest rate or simply make a good mortgage even better. Either way, you'll increase your short- and long-term financial security and increase the odds that hard times won't put you at risk of losing your home.

Increase your long-term net worth. With the savings from refinancing your mortgage, you'll be spending less on interest. That's money you can put away for retirement or use toward another long-term financial goal.

Increase short-term cash flow. If your refinance lowers your monthly payment, you'll have more money to work with on a month-to-month basis. This can reduce the day-to-day financial pressure on your household and create opportunities to invest elsewhere.

Refinancing a mortgage introduces new elements into your financial situation. The risks from your original mortgage are still present, and a few new ones come to the surface.

Overpaying on closing costs.­ Unscrupulous lenders can tack a number of unnecessary and/or inflated fees onto the cost of your mortgage, some of which they may not disclose up front, in the hopes that you will feel too invested in the process to back out.

Overpaying on interest because you want no closing costs. A refinance commonly does not require any cash to close, but one way lenders make up for this is to give you a higher interest rate. Let's say you have two options: a $200,000 refinance with zero closing costs and a 5% fixed interest rate for 30 years, or a $200,000 refinance with $6,000 in closing costs and a 4.75% fixed interest rate for 30 years. Assuming you keep the loan for its entire term, in scenario A, you'll pay a total of $386,511. In scenario B, you'll pay $381,586. Having "no closing costs" ends up costing you $4,925. Can you think of something else you'd rather do with almost $5,000 than give it to the bank?

Losing equity. The part of the mortgage that you've paid off, your equity in the home, is the only part of the house that's really yours. This amount grows little by little with each monthly mortgage payment until, one day, you own the entire house and can claim every penny of the proceeds if you choose to sell it. But if you do a cash-out refinance—rolling closing costs into the new loan or extending the term of your loan—you chip away at the percentage of your home that you actually own. Even if you stay in the same home for the rest of your life, you might end up making mortgage payments on it for 50 years if you make poor refinancing decisions. You can end up wasting a lot of money this way, not to mention never truly owning your home.

Negatively impacting your long-term net worth. Refinancing can lower your monthly payment, but will often make the loan more expensive in the end if you're adding years to your mortgage. If you need to refinance to avoid losing your house, paying more over the long run might be worth it. But if your primary goal is to save money, realize that a smaller monthly payment doesn't necessarily translate to long-term savings.

There are a couple of special refinancing programs that may be particularly beneficial to qualified borrowers.

Home Affordable Refinance Program (HARP). This program is designed to help homeowners who may not be able to take advantage of other refinance options because their home has decreased in value. Its goal is to improve a loan's long-term affordability to help prevent people from losing their homes to foreclosure. To qualify, your mortgage must be owned or securitized by Fannie Mae or Freddie Mac, you must be current on your payments and your income must be sufficient to afford a new mortgage. Note that unless Congress extends this program, it is due to expire Dec. 31, 2018.

FHA Streamline. An FHA Streamline refinance is designed for homeowners who already have an FHA mortgage. Its goal is to provide them with a new FHA mortgage containing better terms that will lower the homeowner's monthly payment. The process is supposed to be quick and easy, requiring no new documentation of your financial situation and no new income qualification. This type of refinance does not require a home appraisal, termite inspection or credit report. One possible drawback for some homeowners is that an FHA streamline refinance does not allow cash out.

VA Streamline. This program, also known as an Interest Rate Reduction Refinance Loan (IRRRL), is similar to an FHA streamline refinance. You must already have a VA loan, and the refinance must result in a lower interest rate unless you are refinancing from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage. The lender may require an appraisal and credit report, though the VA does not require these. Note that the VA and Consumer Financial Protection Bureau recently issued a warning order that service members and veterans have been receiving a number of unsolicited offers with misleading information about these loans.Check with the VA before acting on any offer of a VA IRRRL 

With both the VA streamline and the FHA streamline, it is possible to pay little to no closing costs up front. However, these costs will either be rolled into the mortgage or you'll pay a higher interest rate in exchange for not paying closing costs. So while you won't be out any cash up front, you will still pay for the refinance over the long run.

Any good refinance should benefit borrowers by lowering their monthly housing payments and/or shortening the term of their mortgage. Unfortunately, as with any major financial transaction, there are complexities that can trip up the unwary buyer and result in a bad deal. Knowing about the process will help you find a lender and a refinancing program that offer the best value for your situation.