Is Now the Right Time to Refinance? 2 Things to Consider
Originally published on July 8, 2016, updated on June 1, 2020.
With everything that's been going on in the world, interest rates have dropped dramatically. For some people, that might mean it's the perfect time to refinance. So, does refinancing make sense for you?
Two critical things to consider when making that decision are:
- What are your FICO® Scores, and will they help you qualify for the great rates currently being offered? Sure, the rates might be low right now, but if your credit scores are also low, you won't be able to enjoy those rates.
- Know the actual rate you'll be getting. The "prime rate" is the rate you'll see advertised. This is based on the federal funds rate which is the interest rate banks charge other banks. The "mortgage rate" is the interest rate a lender charges a home buyer—that's the rate you will pay when refinancing. Be sure to know your mortgage rate before making any final decisions.
Costs - Refinancing isn't Free
If you decide to refinance, you probably based much of that decision on the savings you'll enjoy over the course of the loan. Remember that the savings you calculated are most likely "gross," not "net." There's more math in the equation than meets the eye.
- For example: consider the number of months you have remaining on your existing mortgage versus the number of months you'll be paying off your refinanced mortgage. Even if you get a lower mortgage rate, extending the length of time to pay it off could cancel out any savings.
- A loan origination fee is typically charged by lenders to analyze, prepare and properly submit your loan. This fee of .5% to 2% of your loan amount will eat into the money you're expecting to save on your refinanced loan.
- Additional fees might include closing costs, such as credit fees, appraisal fees, points insurance, taxes, escrow and title fees. These fees bite into your savings. This refinancing calculator can help you figure some of these numbers out.
Once you add up the costs, take into consideration another well known "rule of thumb": one should refinance when interest savings cover the loan costs in two years or less. Will this be true for you? Just something else to think about when making that "should I or shouldn't I?" refinance decision.
The Final Equation
Okay, so you've done your research, determined whether or not to cash some equity out of your home, and now it's time to make the decision: refinance or not. You can use the simple formula below to calculate how long it should take to amortize the refinance costs before you "breakeven" and your savings can start.
REFINANCE COSTS/MONTHLY SAVINGS WITH NEW MORTGAGE PAYMENT = NUMBER OF MONTHS BEFORE BREAKEVEN POINT
So, for example, if your refinance costs are $5,000 and you're saving $350 per month with your new mortgage payment, it will take about 14 months to break even. Are you planning to stay in your home for another 14 months? If yes, refinancing could make sense. If no, refinancing might not be the best way to go.
Of course, FICO offers a few great resources to help you come to an informed conclusion on the issue. Check out our Refinancing Educator and then head to the "Am I better off refinancing" calculator to crunch some numbers.
If you're getting lost in all the terminology, we've got you covered there, too. Below is a glossary of common terms used in the refinancing process. It's a good idea to have these memorized before you start the process (or even before you start researching).
Cash-out Refinancing During the Pandemic
During the coronavirus pandemic, many people are considering taking cash out of their home's equity to help pay for upcoming financial shortfalls. Is that a good idea or a bad one?
For some, this could be a good move because it'll help pay bills while maintaining their credit score. For others, it could lead because they'll be putting their home equity on the line. If their income takes a hit for a long period and they don't have savings to fill the gap, the bank could foreclose on their home.
With a cash-out refinance, your loan is replaced with a new one at an amount higher than your current loan balance. You can then withdraw the difference between the two mortgages and use the money to assist you through the rough financial patch.
List of terms used in mortgage refinancing:
Adjustable-Rate Mortgage Also called an ARM, this type of mortgage has an interest rate for a set time. During this period, the interest rate is lower. Once the initial period ends, the rate will adjust based on an index and will continue to adjust at set intervals.
Annual Percentage Rate This is either "fixed" or "adjustable" and is the rate of interest that will be paid back to the mortgage lender.
Amortization This is the schedule for how the loan is intended to be repaid and typically calculates the monthly breakdown of how much interest you pay and how much is paid on the amount borrowed.
Closing Costs These are expenses/costs paid by the homeowner/home buyer during the mortgage process. Closing costs can range from attorney and recording fees to points, escrow and title fees.
Equity This is the difference between the value of your home and the amount of your mortgage loan. As the value of your home increases and the amount of the loan decreases, your equity will grow.
Fixed-Rate Mortgage This type of mortgage has a set interest rate and loan term, typically ranging from 10 to 40 years.
Origination Fee This fee is paid by borrowers to lenders and generally includes an application fee, appraisal fee, and fees for all subsequent and associated costs of the loan.
Principal This is the amount of money borrowed for the mortgage. The principal decreases as each mortgage payment is made.
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