When should I Refinance My Mortgage?

There’s little doubt, if you’re a homeowner you’ve watched interest rates fall to historic lows. Now, those rates are slowly beginning to rise. The Federal Reserve continues to signal it will end its current position, backing off its quantitative easing initiative. Of course, that will necessarily cause interest rates to rise. However, even now, rates are still at near historic lows. If you hesitated, or, waited for the right time, the window is beginning to close.

Rates are incrementally rising, which causes some confusion when it comes to deciding about refinancing. If you are able to gain a lower rate than what you currently have, that seems to be a green light. If only it were that simple. Just because you might step down a quarter or half basis point doesn’t necessarily mean it’s a worthwhile endeavor. Even if you are able to shave off a full point, that doesn’t mean it will be a smart financial decision.

When should I Refinance My Mortgage?

First, understand what refinancing is, and, what it isn’t. A common misconception is refinancing is a kind of repackaging or restructuring of a current home loan, and, that’s simply not true. Refinancing is the process of getting a new home loan to amortize part of your existing mortgage note, and, get a lower interest rate in return on the balance. This means you’ll still have to qualify for a mortgage, though this is usually made easier because of equity.

“Homeowners who missed the boat this time may wonder if refinancing is worth it the next time rates come down. A general rule of thumb for mortgage borrowers is to refinance when rates decrease by half of a percentage point. But because of their larger loan size, jumbo borrowers may save substantially even with one-eighth of a percentage-point drop.” —Wall Street Journal

It’s also important to note that there are two types of refinancing: rate-and-term refinancing, and, cash-out refinancing. The former allows you to refinance the balance, or, what you owe, at a lower rate. Cash-out refinancing is a new loan that exceeds your balance, and, you use the proceeds to pay off debt.

Break-Even Analysis or Point

In either scenario, particularly a rate-and-term refinance, there’s a mathematical formula which determines if it’s financially wise to get a new mortgage on the balance owed. This is done by taking the amount of closing costs and dividing it by your monthly savings on the new rate. For instance, if closing costs total $3,000, and saves $100 per month, the break-even point comes at 30 months.

Next, you’ll take the formula a step further by looking at your own situation, which is to say, how long you’ll stay in the home. If you plan on staying in the home for 3 years or more, refinancing is worth the time, effort, and expense. However, if you plan on moving or might move in thirty months or less, it’s really not worthwhile. In addition, there are other considerations:

  • Your debt-to-income ratio. When you first bought your home, the lender measured your debt-to-income ratio or DTI — your gross monthly income compared to your monthly debt obligations (which include secured and unsecured debts, but not living expenses, such as food, clothing, utilities, et cetera). That ratio has likely changed since that time. You might have a new credit line or two, had a change in your income, or, both. You’ll need to know this number before jumping into the process.
  • Your neighborhood trend. If your neighborhood is on the rise, that’s a good thing, generally speaking. However, if you live in a neighborhood plagued by distressed properties — short sales and foreclosures — that will have a negative impact on your home’s market value.
  • How you’ll pay the closing costs. Even if you have an acceptable DTI, your home is in a good neighborhood, and, you plan on living there past the break-even point, it might still be unwise to refinance. The reason why is if you elect to roll your closing costs back into the new loan. That changes the break-even point, and, means you’ll likely pay a higher interest rate, add to your existing balance, or, both.

Your home’s appraisal value is another consideration. It will be appraised for refinancing, and, this is critical to being approved. Even if you’ve made improvements, it doesn’t necessarily mean your home will be worth much more.

All of this isn’t to say you’re necessarily stuck where you are. You can also consider selling your current home and buying another.