Mortgages and Mortgage Refinancing
When is it Smart to Refinance your Mortgage?
The right time to refinance is when it will save you money. It's as simple as that.
However, it normally saves you money in the long run. In the short run, it's likely going to cost you money. Your costs could be penalties for refinancing, including points, fees, a new property appraisal (if required), and potentially title insurance. If you move from one lender to another, you can definitely expect to need an appraisal and title insurance. If you can refinance with your current lender, you may be able to avoid some costs, but this will depend on your lender and what that lender is willing to waive.
So, when will you most likely save money? There are three basic scenarios that generally work in your favour:
- Interest rates are dropping, and you are locked in at a rate more than 1.5 % higher than the current rate.
- You can reduce your overall monthly payments enough to offset any costs of refinancing penalties.
- You have credit card debt that is not getting paid off, your payments are too high, and you are finding yourself in financial difficulty. (This is an extended circumstance of point #2.)
Let's look at the first scenario. You're locked into an interest rate that is too high. How can you be sure you'll save over the long run if you refinance? You'll have to look at the type of mortgage you have. If you have an ARM (most folks do) then you'll want to compare the lifetime caps of your mortgage versus today's ARMs to determine if your rate is high enough to justify refinancing. Also, the likelihood of saving money increases if you plan to hold onto your property for at least 5 years. If you are planning on moving in the next year or so, refinancing may not be the best option.
What's at issue is how long it will take to recoup the costs of refinancing and start to see a dollar benefit back to you. Let's say you've added up all the costs, and you've got a number of $3000. However, refinancing actually saves you $150 a month. It looks as if you'll have made back the costs in 20 months and your saving will then be yours. But, you have to be careful when calculating your benefits. There are catches.
The biggest is that you'll lose tax benefits by refinancing. Interest paid on your mortgage is tax deductible. If you are paying less on your mortgage, you'll also be claiming less on your taxes. As a result, depending on your tax bracket, some of your savings will be "clawed back" in tax. In fact, if your federal tax rate is 28 %, and you use the scenario we've used here, your real savings will be $108 a month (once your income tax changes are factored in). So, it will actually take you 28 months to get your costs back.
So, keep in mind the changes to your taxes when you are thinking about refinancing, and this will give you a true picture of the benefits to you.
It's the same calculation if you are refinancing to reduce your overall monthly payments, either by rolling credit card debt or other consumer debt into your mortgage. The overall costs should eventually "pay back" any cost to the refinancing. However, if you are doing this to avoid bankruptcy, then you need to consider your financial health first, and recouping your costs second.
If you have decided that refinancing works for you, be sure to comparison shop! Also, read all the fine print on your current mortgage. Some have prepayment penalties, and they can be quite high.