Stop! Read This Before Refinancing

By Markets Fool.com

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Source: Wikimedia Commons user Silverstone1.

If you own a home, falling interest rates may give have you wondering whether it's time to refinance. That makes sense: Even a modest drop in interest rates can save you tens of thousands of dollars over the life of your loan.

But should you actually do it? Here are the key points to consider.

The extent of your interest rate drop Depending on your existing rate, the recent fall in interest rates might be a big deal or a drop in the bucket. So how big of a difference is big enough?

A common rule of thumb is to consider refinancing if you'll save 1% or more. That's because refinancing isn't free: You pay for the closing costs of the new loan, and in some cases you might also have to pay a "prepayment" penalty. You don't have to use the 1% guideline, but make sure you figure out how long it will take you to recoup the cost of the refinance based on your new loan payment.

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For example, let's say you got a $150,000 mortgage 10 years ago at an interest rate of 4.5%. You've paid off about $30,000 so far and you're looking to refinance the rest without resetting the term of your mortgage. Your options might look something like this:

Your Mortgage

Refinance Option 1

Refinance Option 2

Loan Amount

$150,000

$120,000

$120,000

Term

30

20

20

Rate

4.5%

3.75%

3.25%

Closing Costs

$1,800

$1,800

Insurance

$1,020

$1,020

Monthly Payment

$760

$695

$680

How Many Months to Break Even

43

35

Both refinancing options include the average closing cost on a new mortgage (1.5%, according to Fannie Mae) and the new average Federal Housing Administration mortgage insurance premium of 0.85%. As you can see, you're saving a decent amount every month, but with your closing costs and insurance included up front, it'll take you about three or four years to recoup the cost of refinancing.

These costs aren't included in your existing mortgage because, assuming you've paid these fees already, they're what economists refer to as "sunk costs." You can't get the money back because it's already been spent, so it should be excluded so you can make a fair assessment of what you should do going forward.

In this case, you would want to think about whether the upfront cost is worth it to you. If you're looking to move in the next five years, are you really saving enough to justify the expense and the hassle? Only you can decide. On the other hand, if you're planning to stay put for a few decades, even a modest change to your payments could save you an enormous amount of money.

The size of your loan
If you have a jumbo loan that you've since paid down so that the principal is below the limits set by Fannie Mae and Freddie Mac, a "regular" refinance might make sense. Currently, that loan limit is $417,000 for most single-family homes, with higher limits in Alaska and Hawaii.

Jumbo loans typically have higher interest rates than regular loans, so the savings might be all the more significant if you go the refinancing route. Take a look at the numbers and see if it makes sense for you.

The term of your loan
While going for a new 30-year loan might look attractive from a monthly payment standpoint, it can backfire if you're looking to eventually own your home (this is why the example above doesn't provide for an extended loan term).

In this case, resetting your loan term back to the maximum term won't help you in the long run. Instead of building equity, you'll spend several more years primarily paying off interest, and with a longer-term loan, you might cut into your retirement budget, especially if you were hoping to own your home outright by then and not pay housing costs.

Instead, consider looking at refinancing options that don't change the remaining number of years on your current mortgage. This gives you more of an apples-to-apples comparison to what you're already paying, and it also means you won't lose the time you've already spent paying off the house.

Keep an eye on fees
You've already taken account of closing costs, prepayment penalties, and loan term. But you also need to make sure you understand any other expenses that are tacked onto the new mortgage.

This includes options that add the closing costs to the mortgage so that you don't pay them up front. That might look good right now, but it can end up costing you a lot more over the years.

And that's the thing about mortgages: You're not talking about months or even years; typically, you're looking at decades. So be sure to get an understanding of the total, long-term cost of your current mortgage relative to your new options. It will keep you focused on the big picture and help you avoid a refinancing mistake that seems attractive today but costs you later on.

The article Stop! Read This Before Refinancing originally appeared on Fool.com.

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