Should I refinance my mortgage? How to know if the time is right

Should you refinance your mortgage now? Refinancing could be a chance to save money, consolidate debt and adjust your loan terms, but it might not be the right time for your individual circumstances. A rate reduction of 1%, or even less, can be worthwhile depending on your loan balance, closing costs, how long you plan to stay in the home, and your overall financial goals, so evaluate your situation carefully.

Key takeaways:

• Consider refinancing when the potential interest rate savings justify the costs, and you intend to remain in your home long enough to reach the break-even point.
• Evaluate your credit score, home equity, existing debt and long-term financial goals to determine if refinancing aligns with your overall financial strategy.
• Carefully weigh the pros and cons of rate/term refinances, cash-out refinances and loan type modifications to identify the most suitable option for your specific situation.
• Use a break-even formula or calculator to accurately estimate the time required to recoup refinancing expenses.
• Monitor interest rate changes and work with a qualified mortgage professional to make well-informed refinancing decisions.

The right time to refinance: Key financial indicators

Refinancing can help you save or reach your financial goals, but it's not a one-size-fits-all solution. Before deciding to refinance, carefully evaluate these key financial factors to determine if works with your individual circumstances:

• How will a new interest rate affect you? While a lower interest rate is often main reason to refinance, the extent to which a new rate improves your financial situation is what truly matters. Generally, a decrease of around 1% in your interest rate might be a good trigger to start seriously looking into refinancing. Consider setting rate alerts to stay informed of rate changes and compare personalized rate quotes from multiple lenders.
• What's your credit score? A higher credit score generally unlocks more favorable interest rates. Before applying, review your credit report for any inaccuracies and take steps to improve your score. Remember that even small improvements can positively impact the rate you receive. An increase of 50 points or more in your credit score might improve your refinancing options. Credit monitoring services can help you track your progress.
• How much equity do you have? Reaching a 20% equity level in your home can unlock significant benefits, allowing you to potentially eliminate private mortgage insurance (PMI) on conventional loans or making it possible to refinance from an FHA loan to a conventional loan. Determine your home equity by subtracting your mortgage balance from its current appraised value.
• How long do you plan to stay in your home? Before refinancing, carefully consider your long-term plans. Calculate how long it will take to recoup the costs of refinancing, and factor that into your decision. Be realistic, as refinancing may not be the best option if you plan to move soon.
• If you have high-interest debts, a cash-out refinance might be a viable strategy for debt consolidation. This can simplify your finances and potentially save you money on interest. However, it's crucial to address the underlying spending habits that led to the debt in the first place. Consider developing a budget and seeking financial counseling to ensure long-term financial stability.

Reasons to refinance your mortgage

There are several reasons you might consider refinancing into a new mortgage with different terms.

• To lower your monthly mortgage payment

  The most common reason for refinancing is to take advantage of lower interest rates to reduce your monthly payment and overall interest costs. Even a small reduction in your interest rate can lead to big savings over the life of your loan. Use those extra funds to save or pay down other debts. Consider automating your savings to make the most of the extra cash flow.

• To switch mortgage loan types

  By refinancing, you can switch from an adjustable-rate mortgage, or ARM, to a fixed-rate mortgage. Switching to a fixed-rate loan can lock in your payment and protect you from rising interest rates. You also may be able to move from an FHA loan to a conventional loan to eliminate mortgage insurance if you have sufficient equity. Consider the pros and cons of each loan type before making a decision and consult with a mortgage professional. It is important to know factors to consider when comparing different types of mortgage loans.

• To cash out some equity in your home

  If your home's appraised value is greater than how much you owe on your mortgage, you have equity in your home. To determine how much, you will need to do a little research to find out what your home is worth.
  
  Taking advantage of your home's equity can provide funds for home improvements, debt consolidation or other needs. But be careful with a cash-out refinance. If you run up higher-rate debts like credit cards again, you could end up with lower equity in your home on top of the debt. Be sure to address any spending or budgeting habits that caused the debt in the first place. It's essential to have a solid plan for how you'll use the cash and avoid overspending. Consult with a financial advisor to create a responsible spending plan.
  
  In addition to taking advantage of lower interest rates, you could also benefit from the federal income tax deduction that's generally given for mortgages but not for credit cards or auto loans. Be sure to consult your tax advisor.

• To shorten the mortgage loan term

  Shortening your loan term can help you pay off your mortgage faster and save on interest. Keep in mind, though, that a shorter term typically means higher monthly payments. However, the long-term savings can be substantial and help you build equity faster. This can be a great option if you're looking to accelerate your path to financial freedom. For many, achieving a true sense of financial security happens when they're debt free. That makes paying off a mortgage a big priority. If you started off with a 30-year mortgage, you may want to refinance into one with a shorter term, such as 15 or 20 years. This can also help if you're several years into your current mortgage but want to take advantage of lower rates without extending your term.

Understanding loan-to-value

Loan-to-value, or LTV, is the amount of the loan divided by the home's appraised value. A lower LTV typically means a lower interest rate and potentially more favorable loan terms. Aim for a lower LTV to save money over the life of the loan and to build equity faster. Improving your home and paying down your mortgage are two ways to reduce your LTV.

How to determine your refinance break-even point

A key step in deciding whether to refinance is calculating your break-even point. This is the amount of time it will take for your savings from refinancing to cover the closing costs you incur by refinancing.

To find out how many months it will take for your savings to offset the cost of refinancing, use this formula:

Break-Even Months = Total Refinancing Costs ÷ Monthly Savings

The total refinancing costs are all the fees and expenses associated with the refinance.

The monthly savings are the difference between your current monthly mortgage payment and your new, lower monthly payment.

For example, let's say your new monthly payment will be $200 lower. If your closing costs are $8,000, it will take you 40 months, or a little over three years, to break even ($8,000 divided by $200). In that situation, if you think you'll be moving in less than three years, it could make sense to keep your current mortgage.

Keep in mind that if you plan to sell your home before you reach the break-even point, refinancing may not be worth it. Carefully consider your long-term plans before making a final decision.

Other factors to consider

• Closing costs: Refinancing involves closing costs, which can include appraisal fees, title insurance and origination fees. Be sure to factor these costs into your break-even calculation. Shop around for the best rates and negotiate fees to minimize your expenses. Don't be afraid to ask lenders for a breakdown of all closing costs.
• Your long-term financial goals: Consider your overall financial goals when deciding whether to refinance. Are you trying to pay off debt, save for retirement or fund a major purchase? Make sure refinancing aligns with your long-term objectives. Think about how refinancing fits into your broader financial plan.
• Market conditions: Interest rates can fluctuate, so it's important to monitor market conditions and act when rates are favorable. Keep an eye on economic indicators and consult with a mortgage professional to get expert advice. Understanding the economic climate can help you make a well-informed decision.

If you're not big on formulas, you could also try out an online calculator to determine refinance break even points.‍ ‍ ^{See note 1}

Is refinancing your mortgage right for you?

Strategically timing your mortgage refinance can lead to significant savings and help you achieve your financial goals. By understanding key financial indicators, exploring your refinance options, and considering your personal circumstances, you can make an informed decision that benefits your long-term financial well-being. Refinancing isn't a one-size-fits-all solution, so don't rush into it; take the time to do your homework and make sure it's the right move for you.