When to Refinance Your Mortgage

Welcome to our week-long series on refinancing your mortgage. In this first of five articles, we look at when you should refinance.

When to Refinance Your MortgageAs I mentioned yesterday, my wife and I just closed on the refinancing our mortgage. We purchased our current home in 2004 and obtained a 30-year fixed rate mortgage at 5.625%. We are refinancing the loan to another 30-year fixed rate mortgage at 3.875% (today’s mortgage rates are incredible). And I thought I’d use this opportunity to cover a number of topics when it comes to mortgages, starting with one we hear a lot–“When should I refinance my mortgage?”

While there are a lot of difficult decisions to make when it comes to money, refinancing your mortgage doesn’t have to be one of them. In fact, deciding whether you should refinance your home loan is generally a very simple analysis. Let’s look at the five primary reasons to refinance a mortgage, and then some specific circumstance that can make the decision more difficult.

Refinancing to lower your interest rate

Lowering the interest rate on a mortgage is the primary reason most homeowners refinance their home loan. Back in the day, the rule of thumb was to refi a mortgage when the rate had gone down by at least 1%. Today, a rule of thumb is not enough to make a decision. Instead, divide the cost of refinancing by the monthly interest you’ll save with the lower rate (adjusted for lost tax deductions). The result will tell you how many months it will take you to break even.

In our case, the new home loan will cost us about $5,000 and save us $600 a month in interest. Because our home mortgage interest deduction will be lower, we lowered the $600 savings down to $400 to evaluate the refinancing. Dividing $5,000 by $400 means it will take us about 12 months to break even. Because we have no plans to move in the foreseeable future, refinancing our mortgage was an easy choice.

Refinancing after your credit score improves

In same cases, a refi may be justified if you credit score has improved since you purchased the home. You may be able to purchase a home with a credit score as low as 620, but the interest rate you get won’t be the lowest available. If you’ve improved your credit score significantly, you may qualify for a better rate that makes refinancing your mortgage a smart move.

Refinancing an ARM into a fixed rate loan

Even if rates haven’t gone down, moving from an adjustable rate mortgage (ARM) to a fixed rate mortgage is often worth the cost of refinancing. In fact, in some cases homeowners will pay a slightly higher interest rate with the fixed rate loan. In exchange, however, you get the peace of mind that your rate won’t go up during the life of the loan. With an ARM, rates can go up significantly, depending on the terms of the loan and prevailing interest rates. And given the historically low rates we see today, chances are that the rates on ARMs will increase significantly over the coming years.

Refinancing from an ARM to a fixed rate loan is the approach I’ve taken on investment properties I own along with a business partner. When we purchase the homes, we almost always get 5-year ARMs from a portfolio lender (one who doesn’t sell the mortgage). We get the ARMs because the lender allows us to finance 100% of the improved value of the property. But we always refinance to a 30-year fixed rate mortgage before the five years expires.

Refinancing to lower monthly payments

In some cases lowering your monthly payments is the goal of a refi. For example, even with the same rate, refinancing a 30-year mortgage that has 22 years remaining back out to another 30-year mortgage will lower your monthly mortgage payments. There is a big downside to this approach. First, you extend the time it takes to pay off the mortgage. And second, you substantially increase the amount of interest you’ll pay. In some situations, however, lowering the monthly payment is a necessity.

Refinancing to get cash out

Finally, some refinance their mortgage in order to pull additional cash out. Called a cash-out refinance, this approach has several shortcomings. First, in today’s mortgage market, it can be extremely difficult to qualify for a cash-out refi, particularly given the low real estate values. Second, the interest rates on a cash-out refi will be higher than if you took no cash out. As a result, it can be an expense way to get at cash. Note that you can typically include closing costs in the refinance amount without being deemed to have taken cash out.

So why do most people refinance a mortgage? Freddie Mac answers this question to some degree in two quarterly refinance activity reports. Here is some data from these reports covering the fourth quarter of 2010:

  • 95 percent of refinance loans were fixed rate
  • 32 percent of borrowers who paid off a 30-year fixed-rate loan chose a 15- or 20-year loan
  • 70 percent of borrowers who refinanced a 20-year loan chose a 15-year loan
  • 46 percent of homeowners who refinanced their first-lien home mortgage lowered their principal balance by paying-in additional money at closing
  • 16 percent of homeowners increased their loan balance (cash out) by at least 5 percent
  • The median interest rate reduction was about 1.25 percentage points, or a savings of 22 percent in interest costs

For a breakdown of the type of mortgage homeowners obtained as part of their refinance, see the tables below. The first table shows refinancing data for the fourth quarter of 2009, while the second table shows data for the fourth quarter of 2010:

Why People Refinance Mortgages

Refi Statistics Q4 2010

Tomorrow we’ll look at Home Affordable Refinance Program (HARP), which can help millions of people refinance their mortgage.

Photo credit: nikcname

Published or Updated: February 16, 2012
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. Ravi Gupta says:

    Great article! At times I’m shocked how many people stay in ARMs during the course of their mortage. It seems ridiculous that people would be willing to let interest rates change on such a big asset.
    I think you make a great point on saving on interest and that refinancing is great way to save money.

    -Ravi Gupta

  2. My parents recently refinanced for lower payments. Right now IS THE TIME to do it! They have saved a boatload. it was a lot of paperwork but well worth it.

  3. Lisa says:

    Hello I have a couple of questions, my current mortgage balance is much higher than my house is worth. If I refinanced my loan would I refinance at what I currently owe on my mortgage or what the house is valued at? Also, my company is downsizing and I may be out of work at the end of this year, if I refinance now, would this kick me out of any opportunity of qualifying for maybe a loan modification or short sale?

    • DR says:

      Lisa, with a mortgage balance higher than the value of the home, it will extremely difficult, if not impossible, to refinance your home. To get the best rates, you need a loan to value ratio of 75%. And loan equal to 80% of the home’s value is about as high as lenders will go. And to answer your second question, I would look into a loan modification now. Your lender should have a department established to handle loan modification requests.

  4. Leigh says:

    Don’t forget to look at the long-term expense too. You’re extending yourself out another 7 years by refinancing from a 30 year to a 30 year mortgage. You need to calculate the cost of the monthly payments those last 7 years too that you wouldn’t be paying if you stayed with your current mortgage. Lowering your term at the same time (not just rate) is the best bet for long-term savings.

    • DR says:

      Leigh, that’s an excellent point. In our case, we wanted the flexibility of lower payments by extending out the term just in case of a financial emergency, but we do plan to pay extra each month to pay off the home in at least 23 years (boy that seems like a looooong time!).

  5. Cedes says:

    My husband and I refinanced with an Energy Efficient Mortgage last September. We took our interest rate from a 6.375% to 4.5%. This saves us $130 per month. We also added nearly $11,000 to our loan without additional qualifying. This money was used for energy upgrades like changing out our furnace and A/C, insulating our attic roof line, encapsulating our crawl space where our ducts are, and airsealing. We’re now saving $120 per month on our utilities compared to before the refi. So with the EEM, we are saving $250 per month, which translates to $3,000 per year! My home is also more comfortable now too. The EEM is an FHA product that has been around since 1995, but it’s hard to find people in the industry that know about it. Structured Energies in Atlanta has done a bunch of them.

    • DR says:

      Cedes, thank your for sharing this information. I had never heard of an energy efficient mortgage before. But after the information you provided and a little research, they sound like a great deal.

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