With mortgage rates at their lowest point since the mid-1950s, you might find yourself wondering if it's time to refinance. Some sources say refinancing makes sense only if current market interest rates are at least 2% lower than the mortgage rate you're paying now. But even if prevailing rates are as little as three-quarters of a percentage point lower than your current rate, refinancing might be worth considering.
Don't decide whether or not to refinance based solely on a cursory comparison of prevailing market rates with your current rate. You need to dig deeper so you can make a fully informed decision.
First, Define Your Goals
Ask yourself, what objectives would you want to achieve by refinancing? Do you want to:
Lower your monthly mortgage payment? You could do this by refinancing to a lower interest rate, but you could also look for a new loan that would extend your payoff period. For example, if you’re currently 10 years into a 30-year mortgage, you could refinance to a new 30-year mortgage – which would mean stretching your remaining 20 years of payments into 30 more years of payments.
Change to a shorter loan term than the number of years left on your current mortgage? By reducing your loan term, you can lower the total amount of interest you’ll pay out over the years.
Tap your home equity? Perhaps you’re looking for extra cash or want to consolidate credit cards or other loans. In a "cashout" loan, you refinance your mortgage for more than you currently owe and get a check for the difference between the amount you owe on the mortgage you’re replacing and the full amount of your new mortgage. For example, say you still owe $220,000 on a $360,000 home and you refinance your mortgage for $240,000. You will receive a check for $20,000 – the difference between the $240,000 new loan and the $220,000 you owe on the old loan – and you will be able to use this check as you wish.
Switch from your current adjustable-rate mortgage (ARM)? With an ARM, the interest rate fluctuates based on an indexed rate plus a set margin, and adjustment intervals are predetermined. Minimum and maximum rate caps limit the size of the adjustment. Maybe you’d rather have a new ARM with better terms -- or a fixed-rate mortgage, in which the monthly payment typically remains the same for the entire loan term.
These are all potentially valid reasons to refinance.
Then, Calculate Your Break-Even Point
Generally, it makes sense to refinance only if you're sure you'll be able to recoup the up-front costs of refinancing during the time you continue owning the home. Before you start down the path toward a refinance, it's important to calculate your break-even point -- the point in time when switching loans will start to save you money, after you’ve taken closing costs, points and any fees on the new loan into account.
Here’s a basic illustration of how your break-even point is determined. If your total, up-front costs to refinance, including closing costs, points, etc., would come to $4,000, and your monthly mortgage payment would decrease by $500, then you divide $4,000 by $500 to come up with your break-even point, which in this case is eight months. At that point, the refinance would start to save you money. Ideally, your break-even calculation will show that you can recover your costs within one year of refinancing.
To determine your break-even point, use the Mortgage Refinance Breakeven calculator on our website.