How Do I Know if a Home Mortgage Refinance Makes Sense?

Key Takeaways

• People refinance their homes to save money or solve a problem.
• Equity can also increase if the value of the home has gone up.
• If you’re refinancing to pay off other debt, you can save a lot in current interest charges.

How do you know if it makes sense to refinance your mortgage? After all, it can be an ordeal, it can cost thousands of dollars, and it can take a significant amount of time. Even though there’s no rule against refinancing as many times as you like, it’s probably not something you want to do on a whim. On the other hand, the rewards can be great if you’ve thought the decision through.

Will it solve the problem?

People refinance their homes to save money or solve a problem. For example, if you’re refinancing to switch from an adjustable rate mortgage to a fixed one to avoid rising interest rates, a refinance could very well solve the problem. However, people have many reasons to refinance their homes:

• Move from an adjustable rate to a fixed rate
• Lower interest rates
• Finance a home improvement
• Pay off other debts
• Cash out (limit of once per year)

Each raises several questions that need to be answered before you know if a refinance will really solve your problem.

Are you eligible for better terms?

In addition to getting a new, lower interest rate, homeowners can sometimes get a better deal on their mortgage terms if they have built up at least 20% equity in their homes. Most of the first several years of owning a home almost all the payment is applied to the interest and not the principal. So, it can take time—without a big down payment—to reach the goal of paying 20% of the principal—known as 20% equity. If you’ve been paying on your mortgage for a while, you may have reached that benchmark.

Equity can also increase if the value of the home has gone up. Say if you bought the house for $200,000 and had 10% equity or $20,000. Because the neighborhood became very popular, the house is now worth $300,000. That value gain is added to your equity. You may not have $100,000 extra dollars in equity, but you will have some. That extra equity may qualify you for a lower interest rate and release you from paying Private Mortgage Insurance.

Another reason you might be eligible for better terms is if your home was initially purchased as a jumbo mortgage—a mortgage for a very expensive home—but now you’ve paid the principle down and only require a conventional mortgage which has lower interest rates.

Homeowners can also sometimes negotiate for lower interest rates if their credit scores have risen significantly or if they have additional cash to add to a down payment. If your financial situation has changed for the better, it might make sense to refinance.

How long do you plan to be in your home?

This is a big one. Refinancing may cost upward of $2,000. Often, it’s between 2% and 5% of the total loan amount. Generally, it’s not considered worth the time and money unless you intend to stay in your home at least long enough to recoup those costs and more. So, if you’re refinancing to lower your interest rate (and therefore your payment), you need to be making the new payment long enough to gain back what you paid in closing costs and then some.

Does the math work out?

If you’re refinancing to pay off other debt, you can save a lot in current interest charges. But will you end up paying a lot more in interest because you’re making payments for a longer period of time?

Let’s say you have a $10,000 credit card debt and you’re paying 16% interest. You figure you could pay off that debt with a mortgage refinance and only be paying 5% interest. However, the savings may not add up. Currently, you could pay off that credit card in a year for less than $1,000 a month. In that scenario, you would pay less than $900 in interest. Instead, if you add that debt to a mortgage at 5% interest for 20 years, you wind up spending nearly $6,000 in interest on top of the $10,000. Moreover, there’s a risk that, with that credit card payment off your plate, you’ll be more tempted to see future credit offers as attractive and rack up debt again.

The same is true with getting cash out. Some homeowners, especially older people with large amounts of equity in their homes take out reverse mortgages—they borrow money back from their own homes to supplement their incomes. This and other needs may make it make sense to refinance and get cash out. Remember though; you’re adding to your debt and reducing your assets which could impact your future.

What are the risks?

If you’re planning to refinance to pay for home improvements or an addition, will you be able to recoup your costs when you sell the home? Many people only recoup about 50% of what they paid for their home improvement when selling the home. It’s possible to put a lot of money into a home with the expectation that the remodel will raise the price of the home far above what is reasonable to expect in that housing market. So, you need to be realistic and market savvy to determine which home improvements or additions are worth it.

Also, are you setting back the clock? If you have been paying into a 30-year mortgage and you refinance, are you starting all over again and racking up those interest costs for the future? That’s a factor in whether it makes sense. The longer you’ve been in a home, the more interest you’ve paid off. If you’ve been paying on your mortgage for many years, starting with a new 30-year mortgage may not make sense.

Have you looked at all the options?

As long as you’re exploring to see if a refinance makes sense, you should look at all the options. For example, what would a refinance with a shorter term yield in savings? Say, 15 years instead of 30? What if, instead of a refinance, you began making extra payments toward your principal? How would that impact your interest savings?

If you're still on the fence or have questions about whether you should refinance your mortgage, talk to the experts at Credit Union of Texas. We can help you examine whether refinancing your home makes sense.