When does refinancing make sense?

 

When refinancing to a lower mortgage rate, the key factor is whether you’ll save money. In other words, will you save enough with a lower rate to offset the closing costs you pay to refinance? So how do you know if refinancing is a good decision? When should you refinance?

The usual guideline is that you should be able to reduce your rate by a full percentage point when refinancing, though that isn’t a strict rule. A more reliable way is to calculate your break-even point – that is, how long will it take your cumulative savings from a lower rate to exceed the fees you paid to refinance?

If you can reach your break-even point in 3-4 years, you’ll likely benefit from refinancing. Much longer than that and there’s a good chance you may sell the home before you break even – people tend to move every five years or so. However, if you expect to remain in the home a long time, you could still come out ahead even if it takes you seven or eight years to reach your break-even point.

A refinance mortgage rate calculator can be a useful tool here. Many of them are set up to help figure your break-even point automatically.

You’d do a similar calculation if you’re thinking about consolidating a home equity loan or other second mortgage into your primary one. What would the closing costs be and how much would you save each month by rolling the two loans together?

When refinancing to a shorter term, the key is whether you can do so while keeping your monthly payments affordable. If you’ve got 20 years left on your mortgage and can refinance to a 15-year loan with only a small increase in your monthly payments, it would probably be worthwhile to do so. But you don’t want to strain your budget, no matter how much you’d save over the long term.

On a cash-out refinance loan, the question is whether that would be a more affordable choice than other options for borrowing the money, such as a home equity loan or line or credit. Because you’re paying refinance closing costs on the entire mortgage, this option works best if you can reduce your mortgage rate at the same time, or are borrowing a large sum of money.

The decision whether to refinance out of an ARM is a subjective one. How much of an increase in your mortgage rate can you afford? How uncertain are you about the direction rates are headed? The question here is whether you want to buy financial predictability by refinancing.

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