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5 Rules for Refinancing

Scott Sheldon

Mortgage rates are now at the lowest level we've seen in the past year and a half. If you can save money by refinancing your mortgage and have been putting it off, you owe it yourself to explore your options. First, here are five considerations to help you weigh whether a refinance is worth it.

1. The 1% Rate Reduction Rule

Most finance experts recommend that you don't refinance your house unless you can save 1% or more on interest rate. This might make sense for most people, but it's not a one-size-fits-all approach. Many can still benefit by refinancing their house for a less than 1% reduction in their interest rate. Consider these other factors that play a role in determining whether you would really benefit from refinancing:

  • Private mortgage insurance — If you have this fixed expense built into your mortgage payment, dropping this cost by refinancing with a less than 1% in rate reduction can give you a significantly lower payment.
  • Lower financed loan amount — How much you've paid off your original loan amount, thereby putting at you a lower loan amount, is also a factor. Financing any amount lower than your original loan amount with a lower rate and the same term will reduce your monthly payment.
  • Loan term — This one is a biggie. The spreading interest rate on 15-year versus 30-year loans at this time is approximately 0.75%. Consider this: If you have a 30-year fixed rate loan you are two years into at say, 4.25%, and you know you can afford a higher mortgage payment, switching to a 15-year mortgage at 3.5%, knowing the loan will be paid off in 180 months, very well could make financial sense, depending on your income and equity objectives.

2. Re-Starting the Clock

This is probably the No. 1 concern before signing off on refinancing, and it's something you should ask yourself to be sure you're not throwing good money after bad. Here's why: When you take out a fixed-rate mortgage, the loan is based on an amortization schedule so the loan is paid off in full with interest, based on whatever terms the loan is set for — 180 months or 360 months, for example. Each time you refinance your home, the clock does start over on a new loan term. Say you're paying a 5% rate on a mortgage you are five years into, assuming a 30-year fixed-rate. Why refinance to start over for 30 years for a lower rate, say at 4%, when it will take you five years longer to pay it off?

The key to making this work: Even though the new loan comes with a lower payment, continue to make the same payment amount on the new loan that you made on the old one. Doing this effectively prevents the clock from starting over, while saving you substantially on interest over time (compared to the higher rate loan being refinanced away). The difference in the payment savings generated by the refinance goes directly to principal in this strategy and in doing so, you'll accumulate more equity over time.

3. Break-Even Point

The most common way to break even on your refinance closing cost fee would be to take the monthly payment savings generated by refinancing, and divide that figure into the costs required to complete the loan.

For example, if closing costs to refinance are $2,700 in exchange for saving $200 per month, that will take you an impressive 13.5 months to recapture. Generally, if you can break even in two to three years by refinancing, it's a good deal for you.

4. No Fees

You can refinance with no fees by taking an interest rate that's slightly above the current market rate in exchange for the lender providing you a credit below, equal to, or above the amount of your closing costs. This is ideal if you can avoid the fees and still reduce your rate. Say you have a 4.375% 30-year fixed rate mortgage and your lender can do a refinance for you reducing your interest rate from 4.375% to 4.0% and you don't pay any of the closing costs, and you get a lower interest rate in the process, that is a win-win situation.

5. Prepayment

I've seen some homeowners take this approach when deciding not to refinance: "I just stay with my current loan because I'm x years into my loan, despite my rate being above market. I will just start making a larger principal prepayment each month, that way I don't have to pay the extra costs through the refinance process."

Now, if you can't qualify for a mortgage refinance, then yes, this is a good way to continue chipping away at your loan balance. However, if you can qualify, it would be dramatically faster for you to pay off your house with a lower interest rate, and the additional savings created by the refinance, coupled with your fastidiousness in already making a principal balance monthly prepayment. If you can reduce your interest rate in this scenario on a no-cost mortgage or a measurable short-term refi recapture mortgage, it usually works out in favor of the homeowner.

If you're looking to refinance, it helps to have good credit. It's important to be aware of where you stand before you enter the process – you can pull your credit reports and credit scores ahead of time. You can get your credit scores for free on Credit.com, along with a summary of your credit report. Once you know where you stand, work with your lender to see what options are available to you.


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