The hope of many homeowners is that refinancing their mortgage will make owning a home more affordable. However, a number of factors come into play as to whether or not you'll actually save any money by refinancing, or even if you want to try. In many cases, you'll need to spend money before you can save money, so whether or not refinancing will be affordable (let alone valuable) depends not only on your current financial position, but also other considerations, too.
When refinancing your mortgage you need to first decide what your goal is:
- Are you trying to improve your monthly cash flow?
- Do you want to shorten the remaining term of the loan to save money over the long haul?
- Are you hoping to pay off your loan at a certain date?
After you determine the goal of your refinance, figuring out whether that goal is reachable depends on a combination of factors:
- The differential between your existing interest rate versus the new rate in consideration
- How far along you are in your existing mortgage
- How long you plan on remaining in the new mortgage
- How much it will cost you to get the new mortgage
A great place to start -- to see whether or not it's worth refinancing in the first place -- is by running some calculations that look at the intersections of interest rates, costs and time frames. This can help answer the question "should I refinance my mortgage?"
Different goals need different strategies, and your finances will help determine which may or may not be affordable for you.
Refinance goal: Improving cash flow
But it’s your goal that should dictate how you approach your refinance transaction. For example, cash flow improvement is usually best achieved with both a lower interest rate AND a re-lengthening of the remaining term to 30 years. However, if you don't plan on being in your home for the long run, you might look beyond fixed-rate mortgages to find even lower rates on adjustable-rate mortgages with shorter fixed-rate periods (i.e. seven years). You can learn more about this strategy by reading “Refinance into an adjustable rate mortgage”.
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Refinance goal: Long-term interest savings
If you hope to save money in the long haul, re-starting the amortization clock (re-lengthening the loan) all over again won't work. Here’s why: If you are seven years into a 30-year loan, it will be really difficult to actually save money with a new 30-year term -- you would need a huge difference in interest rate to overcome the costs of another seven years of monthly payments. Better you should look to a shorter-term loan, such as 20-year, which would likely bring some break in rate (but not so much in payment, if any) while chopping three years off your remaining term, which creates tremendous savings.
For example, changing from a 7-year old, 4.5% mortgage with an original balance of $250,000 to a new 20-year term at 3.25% will only lower the monthly payment by less than $33 per month, but will save over $53,000 in interest cost. Since they usually have even lower interest rates, going with an even shorter-term loan for your refinance (such as a 15-year mortgage) would save the most interest cost... but in most cases would tend to make your monthly payment less affordable.
Refinance goal: Loan paid off by a certain date
If you've got a certain date in mind when you would no longer like to have to make mortgage payments -- such as an expected retirement date, or when the kids go off to college -- refinancing can be one way to help meet that goal. Some lenders (especially those that retain the servicing of their loans) will allow you to specify a term that meets your needs, such as 8, 13 or even 18 years. Your payments will be based on that term. If your lender doesn't offer such an option, no worry -- you can refinance your mortgage to a remaining term that is close to your goal, then prepay your mortgage to any term you want. If you prefer greater flexibility, you can even refinance to a new long-term loan and prepay to your preferred term, although you'll likely miss any additional interest-rate break that a shorter-term loan would bring... and you'll need greater fiscal discipline to make sure you stay on track to meet your goal.
Factoring refinancing costs
Refinancing isn't free. So there are the costs of refinancing to consider. If you pay refinance closing costs in cash (out-of-pocket), you'll need to remain in the new mortgage long enough to not only recoup what you spent but also to get some actual savings. If it costs you, say $4,000 to refinance your loan, and the break in monthly payment is $100, it will take some 40 months (3.3 years) just to get your money back; any savings from your refinance savings won't start until then. If you end up staying in the mortgage for only four years, you'll end up saving only about $800 over that time, so it may not be worth the hassle. In this instance, you may have improved your cash flow a bit, but you really didn't save any money for your refinancing effort.
If you're wondering about what it might cost you to refinance, here's a tip: Pull out your existing mortgage's documents from your files, and locate the Closing Disclosure form (for loans made after 2015) or HUD-1 Settlement Statement (loans made before 2015). On it you'll see a complete list of the costs you paid when you bought your home (or last refinanced). Since the costs apply to the home in which you live, a new mortgage will likely have highly similar costs. It's about the best estimate you'll find anywhere.
If you have enough home equity available, you can pay costs by burying them in the loan amount (called a "low-cash-out refinance") or trading them off for a slightly higher interest rate (often called a "no-cost" refinance). Since there's no outlay of cash to overcome, this can make savings start as soon as your refinance is closed, but the difference in monthly payment from old loan to new will be smaller from either the higher loan balance or the higher-than-market interest rate than had you paid costs out of pocket. Still, even small differences in interest rate can add up to savings over time; for example, there's a difference of over $12,450 in interest cost for the same $250,000 loan at 3.5% versus 3.25% over a 30-year term.
In the end, whether or not refinancing will be affordable and valuable depends on your financial situation -- where you are today, where you can or will be tomorrow, and how much it might cost you to get there. HSH.com has great refinance calculator that can help you run though the various choices and scenarios to see which works best for you.
If you're considering prepaying your mortgage, you should have a read through HSH's comprehensive Guide to Prepaying Your Mortgage. Also, did you know that prepaying your mortgage can bring the same long-term savings as refinancing? That's something else you might consider, too.
