Refinancing To Convert To An Arm Or Fixed
While ARMs often start out offering lower rates than fixed-rate mortgages, periodic adjustments can result in rate increases that are higher than the rate available through a fixed-rate mortgage. When this occurs, converting to fixed-rate mortgage results in a lower interest rate and eliminates concern over future interest rate hikes.
Conversely, converting from a fixed-rate loan to an ARMwhich often has a lower monthly payment than a fixed-term mortgagecan be a sound financial strategy if interest rates are falling, especially for homeowners who do not play to stay in their homes for more than a few years.
These homeowners can reduce their loan’s interest rate and monthly payment, but they will not have to worry about how higher rates go 30 years in the future.
If rates continue to fall, the periodic rate adjustments on an ARM result in decreasing rates and smaller monthly mortgage payments eliminating the need to refinance every time rates drop. When mortgage interest rates rise, on the other hand, this would be an unwise strategy.
Is It Worth Refinancing For A 1% Lower Rate
Lets take a look at some math to illustrate why the 2% refinance rule falls short, and how even a rate just 1% lower can be quite beneficial:
Loan amount: $500,000 Loan type: 30-year fixed-rate mortgage Current mortgage rate: 4% Refinance mortgage rate: 3% Cost to refinance: $4,000
Thats a difference of nearly $300 a month, which will certainly make it easier to meet your mortgage obligation.
However, it will take just over 14 months to recoup the cost of the refinance . Its actually even less once you factor in increased equity accumulation.
That said, the refinance breakeven period is very short here. So we dont need to follow that 2% lower rate refinance rule.
In fact, even a drop in rate of just 0.50% would result in monthly savings of about $140 and take less than two years to recoup.
Look At Interest Rates
How are interest rates now compared to what you’re paying on your initial mortgage? If rates are significantly lower, you may decide it’s time to refinance.
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Shorten Your Term Length Whenever Possible
Once youve answered the question Should I Refinance, another strategy for saving money is to lower your term-length. The term of your home loan is the amount of time you have to repay the mortgage and along with your refinance rates determines your payment amount.
One common mistake is going from a 15-year to a 30 or even 40-year mortgage. If you do this the calculation weve been using to find your break-even point is no longer valid. In these cases youll never break even and will be losing a boatload of cash because on the interest youre paying for those extra years.
Shortening your term-length allows you to build equity in your home at an accelerated rate and saves you thousands of dollars per year in finance charges. Government programs like HARP 2.0 encourage shorter term-lengths for this very reason. This is why you should consider a 15-year or even 10-year mortgage if you can afford the higher payments.
If you need help with the math when answering the question should I refinance, leave a comment below and Ill be more than happy to lend a hand.
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Youd Like To Pay Off Your Loan Faster With A Shorter Term
In addition to a lower interest rate, a new loan might provide you with an opportunity to get a loan with a shorter term without your monthly payment changing too much. Its all a matter of math.
In some cases, a significant drop in interest will make a shorter loan possible, but in other cases, a shorter loan might actually be more expensive. Wed suggest using a mortgage calculator to do the math and see if a shorter-term loan makes financial sense for you.
Mortgage Rates Have Gone Down
Mortgage rates can fluctuate since theyre impacted by a variety of factors, including U.S. Federal Reserve monetary policy, market movements, inflation, the economy and global factors.
If mortgage rates fall, you may be able to save by securing a lower interest rate than you have on your existing loan.
So how much should mortgage rates fall before you consider refinancing? The traditional rule of thumb says to refinance if your rate is 1% to 2% below your current rate.
Make sure to factor in your current loan term when considering refinance though. For instance, if youre four years into a 30-year mortgage and refinance to a new 30-year term, it will have taken you 34 years total to pay off your home in the end. Plus, youll likely pay more interest over the extended term than if you had chosen a shorter term.
No matter what rates are doing, youll want to check that the math works out in your favor.
Make sure to calculate your break-even point and how the overall costs including total interest of your current mortgage and your new mortgage would compare, says Andy Taylor, general manager for Home/Mortgage at Credit Karma.
Use our refinance calculator to determine if refinancing your mortgage is financially worth it.
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Pay Attention To Fees Especially With Small Loan Amounts
But what if the loan amount were only $100,000? The game changes in a hurry. Your mortgage payment would drop from $477.42 to $421.60.
Thats roughly $56 in monthly savings, not very significant, especially if it still costs you thousands to refinance.
Assuming the cost of the mortgage was still somewhere around $3,000, it would take about 40 months, or roughly three and a half years, to recoup the costs associated with the refinance.
If you were thinking about selling your home in the short term, it probably wouldnt make sense to throw money toward a refinance.
That is likely why this old refinance rule exists. But home prices are much higher these days, so its not a good rule to follow for everyone.
The same goes for any other mortgage rate rule that says your rate should be 1% lower, or 0.5% lower.
Whether its favorable or not really depends on a number of factors, such as the loan amount, closing costs, and expected tenure in the home.
If we dont know the answer to all those questions, we cant just throw out some blanket rule for everyone to follow. Again, dont cut corners or you could find yourself in worse financial shape.
Tip: Pay close attention to the closing costs associated with the loan. Simply looking at the rate and payment isnt good enough.
What If I Cant Pay My Current Mortgage
If youre out of work right now and finding it hard to pay your mortgage, theres good news for you. Depending on your specific situation, you may be able to have your mortgage payments lowered or put on hold.5
Doing that can really help to free up the burden you might be feeling right now if youre worried about when youll see your next paycheck.
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Refinance To Reduce The Length Of The Loan
As a homeowner, you sometimes could refinance your mortgage when interest rates fall. Without making many changes to your monthly payment, you could get a significantly shorter term.
For a 30 years fixed-rate mortgage on a $200,000 home, refinancing from 9% to 5.5%. You can cut the length of your mortgage by half with a slight change in your monthly payment from $1,609 to $1,634.
On the other hand, if you are already on a 5.5% for 30 years, which comes to $1,135, refinancing to a lower rate of 3.5% will see your monthly rate rise to $1,430.
I dont think I can refinance, said Jamey K. of Sacramento, California. Im retired, and my income is much lower now about half of what it used to be. I bought my house when I was working, and I barely qualified then.
Lets look at a scenario like that of Andy, who has 24 years left on his original 30 years mortgage but is planning to retire in 15 years. It would make sense for Andy to refinance this to be paid off when he retires because his income will be significantly affected, and unable to continue after retirement.
A 15-year mortgage will be just perfect for Andy. Check out the sample below for a better understanding.
I used a constant rate of 5.5% but note that shorter-term mortgages usually attract lower rates.
Some points to take note of under this example
You Want A New Loan Term
Maybe you want to refinance into either a shorter term or longer term.
Let’s say you have 20 years left on your mortgage, and you refinance into a 15-year term. You’ll pay off your mortgage five years earlier and save a ton in interest.
Or you have 20 years left on your mortgage and refinance into a 30-year term. By spreading out your payments over a longer period of time, your monthly payments will go down.
Whichever option you choose, just be aware of the pros and cons. Refinancing into a shorter term saves you money in the long run, but your monthly payments will be higher. Refinancing into a longer term lowers your monthly payments, but you’ll pay more over the years.
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How Many Times Can You Refinance Your Home
If you ask financial experts how many times is too many, the answers vary.
Sometimes you have to sit tight. If your has decreased, you may not qualify for the best rate this time around, and youre likely better off waiting until you improve your credit score.
If youre looking to take advantage of a lower rate, and the current rate isnt at least 1% lower than your current mortgage rate, refinancing may not make financial sense.
When Is It Worth It To Refinance
Refinancing is usually worth it if you can lower your interest rate enough to save money month to month and in the long term. Depending on your current loan, dropping your rate by 1 percent, 0.5 percent, or even 0.25 percent could be enough to make refinancing worth it.
The benefits, of course, can be huge.
A lower interest rate means youll have lower monthly payments compared to your existing mortgage. And it often means youll save thousands over the life of the loan.
But you have to weigh those savings against the inherent downsides of mortgage refinancing:
- You have to pay refinance closing costs on the new mortgage, which are typically 2-5 percent of the new loan amount. These include origination and application fees, along with legal and appraisal fees
- You restart your loan term from the beginning, usually for another 30 or 15 years
- If your new interest rate isnt low enough, you might actually pay more interest in the long run because you pay it for a longer time
Plus, most people dont stay in their homes long enough to pay their mortgages off. So you should make sure the savings you calculate are realistic. Account for the amount of time you plan to keep your mortgage and the upfront cost of refinancing.
In short, the numbers in this article are only examples. You can use them as guidance, but make sure your refinance decision is based on your own loan details and financial goals.
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Consolidate Your Second Mortgageonly If Its More Than Half Of Your Income
Some homeowners with second mortgages want to roll it into a refinance of their first mortgage. But not so fast! If the balance on your second mortgage is less than half of your annual income, you would do better to just pay it off with the rest of your debt through your debt snowball.
But if the balance is higher than half of your annual income, you could refinance your second mortgage along with your first one. This will put you in a stronger position to tackle the other debts you might have before you pull your resources together to pay off your mortgages once and for all!
Refinancing To Tap Equity Or Consolidate Debt
While the previously mentioned reasons to refinance are all financially sound, mortgage refinancing can be a slippery slope to never-ending debt.
Homeowners often access the equity in their homes to cover major expenses, such as the costs of home remodeling or a child’s college education. These homeowners may justify the refinancing by the fact that remodeling adds value to the home or that the interest rate on the mortgage loan is less than the rate on money borrowed from another source.
Another justification is that the interest on mortgages is tax-deductible. While these arguments may be true, increasing the number of years that you owe on your mortgage is rarely a smart financial decision nor is spending a dollar on interest to get a 30-cent tax deduction. Also note that since the Tax Cut and Jobs Act went into effect, the size of the loan on which you can deduct interest has dropped from $1 million to $750,000 if you bought your house after Dec. 15, 2017.
Many homeowners refinance to consolidate their debt. At face value, replacing high-interest debt with a low-interest mortgage is a good idea. Unfortunately, refinancing does not bring automatic financial prudence. Take this step only if you are convinced you can resist the temptation to spend once the refinancing relieves you from debt.
It takes years to recoup the 3% to 6% of principal that refinancing costs, so don’t do it unless you plan to stay in your current home for more than a few years.
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Know Where Your Credit Stands
Since your credit can affect your interest rate, you should know what kind of shape its in. If its not in great standing, you may want to take steps to improve it before you refinance.
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The Classic Rule Of Thumb
Let’s start with the percentage rule. This one’s a classic. Though the numbers vary between 1% and 2%, this is the oldest rule of thumb about when to refinance. The wisdom is this. If current interest rates are at least 1% lower than the mortgage rate you are currently paying, then it makes sense for you to refinance your home.
Simple enough, right? Unfortunately, this rule does not take enough into account. It has so many holes in it, you’d be better off tossing some magic jellybeans in the air and waiting to see how they land. This refinance rule of thumb doesn’t consider: how much your closing costs are, what your tax rate is, how long you’re going to stay in the home, and other important factors.
In a recent article on the Wall Street Journal site, author M.P. McQueen states that “people who followed the one-point rule could have refinanced five or six times in the last 15 years, paying so much in fees that the savings would likely be wiped out.” Exactly.
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Other Good Reasons To Refinance
Most people who refinance their existing home loans want to save money by getting a lower monthly payment and a lower interest rate.
But there are other reasons to refinance. While your new mortgage should save you money, there are several ways a loan can do this and they dont always include a lower rate:
1. Replace an ARM
Rates on adjustable-rate mortgages will eventually start fluctuating with the broader market each year. If you have an ARM, refinancing lets you lock in a fixed rate based on current market conditions and your credit profile.
Getting a fixed-rate mortgage can protect you from the possibility of paying a lot more interest later.
Even if you end up with a higher payment on your fixed-rate mortgage at first, the loan could pay off a lot later if interest rates increase.
2. Get rid of mortgage insurance
FHA and USDA loans charge ongoing mortgage insurance fees. Homeowners pay these fees along with their monthly mortgage payments to protect mortgage lenders from losing money if they default.
In many cases, FHA and USDA homeowners keep paying mortgage insurance for the life of the loan.
But you can eliminate these fees by refinancing into a conventional loan which may not require mortgage insurance coverage. Conventional loans require private mortgage insurance , but only until the loan balance gets paid down to 80% of the original loan amount.
3. Cash out home equity
4. Shorten your loan term