How to Tell If Refinancing Is a Good Idea

Homeowners who aren't happy with their current mortgage have the option to refinance, meaning they replace their mortgage with a new loan. And whenever interest rates drop, there's a flurry of ads urging homeowners to refinance and take advantage of the lower rates. However, interest rates are only one of the factors you should consider before refinancing your home.

Your plans for the future

If you're planning to sell your house within the next couple of years, refinancing is rarely a good idea. Every time you refinance, you incur a bundle of fees associated with the new loan. These fees are typically somewhere between 3% to 6% of the loan amount. So even if your new loan is a substantially better deal than the old one, it'll take a while to break even on all the money you spent on fees.

For example, let's say you refinanced into a $200,000 loan and paid 5% in fees, or $10,000. Your new loan gives you a monthly payment that's $400 lower than your old monthly payment. To figure out how long it will take you to break even, divide the refinance fees (in this case, $10,000) by the amount you're saving each month with the new loan: $10,000 divided by $400 equals 25, so it'll take you 25 months to make up the cost of the fees and start saving money. If you were to sell the house 18 months after the refinance, then the new loan would have cost you more money than you'd saved.

Your credit score

Having a high credit score translates to a substantially better rate on pretty much any credit product, home loans included. If your credit score is 720 or higher, you can usually qualify for the best mortgage or refinance rates available. On the other hand, if your credit score is under 620, you'll have a hard time getting any mortgage.

If your credit score has substantially improved since you took out the first mortgage on your house, refinancing may allow you to lock in a much better rate -- especially if interest rates have dropped in the meantime. However, if your credit score has dropped for some reason, think twice before refinancing, because you probably won't get as good a deal as your existing loan.

Your financial situation

Some homeowners find it difficult to keep up with their monthly payments. Perhaps they got laid off or suffered a cut in income, or they might have run into a sudden spike in expenses thanks to a new baby or other lifestyle change. If this sounds familiar, a refinance may be a good idea. You can refinance into a longer loan term, reducing your monthly payment to the point where you can more easily afford it.

If you're in the opposite situation -- your financial situation has improved significantly and you want to get rid of your mortgage faster than you originally planned -- you could refinance into a shorter loan term, but it's usually a better idea to just make extra payments on the loan. While a shorter loan term does usually come with better interest rates, it's unlikely that the improvement will be enough to make up for the refinance fees.

The type of mortgage you hold

If you have an adjustable rate mortgage or a balloon mortgage and the balloon is about to go up, refinancing can definitely be a good idea. In fact, most homeowners who take balloon mortgages do so with the idea that they will refinance before the balloon payment becomes due. And when an ARM hits its variable-rate period, your interest rate -- and monthly payment -- can suddenly become unpredictable.

However, jumping automatically into a refinance just because the ARM has switched to variable-rate mode isn't always a good idea. First, pull out your loan paperwork and check the "adjustable-rate rider" portion of the document. This is the part that explains how your mortgage's interest rates work, and the rules for how much and how fast those rates can change. ARMs typically have limits on how much the rate can go up in any given year and how high the rate can climb in total. If those terms look pretty favorable compared to current fixed-rate terms, consider sticking with your ARM for a while longer.

Comparing refinance offers

If you decide to pursue refinancing, pay close attention to both the interest rate and the annual percentage rate (APR) on the offers you receive. Of the two, APR can be a more informative number because it includes both the interest rate and the fees the lender charges over the life of the loan. Other factors to consider include the monthly payment, closing fees, the term, and any limits to the loan, such as a prepayment penalty. If you're having trouble understanding the loan terms, consider taking all the offer documentation to a financial advisor and asking him or her for guidance. Given what's at stake, making an informed decision is crucial when it comes to refinancing your home.

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