When is it a good idea to refinance your mortgage? Should you
take advantage of the historically low interest rates now
available, or are there hazards to be leery of?

The general rule of thumb is that refinancing is worthwhile if
you can reduce your interest rate by a full percentage point or
more. But that’s only a very rough guide – for some borrowers, a
reduction of only half a percent may still produce significant
savings, particularly if it’s a large mortgage. And the interest
rate is only one factor to consider when refinancing.

With that in mind, here’s a few of the key points to consider
when deciding whether to refinance your mortgage.

How much can you save?

For refinancing to be worthwhile, it has to save you more than
you spend in fees to refinance. Since refinancing means replacing
your current mortgage with a brand new one with better terms,
you’ll have to pay many of the same closing costs you did when you
first bought your home – origination, appraisal, title search,
etc.

Generally, it will cost about 2-3 percent of your loan balance
to refinance, although this again is just a rough guide. The actual
amount will vary from lender to lender, which is why it pays to
shop around, and from state to state.

Use a mortgage calculator to figure out how much you’ll save
each month on the new mortgage versus the old one, then figure how
many months it will take for your savings to exceed what you’ll pay
in closing fees. That’s your break-even point. So if it’s going to
take 48 months to reach the break-even point, it’s not worth
refinancing unless you plan to own the house for at least that
long.

Can you shorten your term? Lengthen it?

An important, but often neglected, aspect of refinancing a
mortgage is the length of the new loan. If you’ve had your current
30-year mortgage for five years and refinance into another 30-year
loan, you may cut your monthly payments but you’re also extending
your loan term another five years. This not only delays the time
when you’ll pay off your mortgage, but could actually cost you more
in interest by stretching out the payments, even if you’ve reduced
the interest rate.

A better choice is to choose a new mortgage with a term that
matches the time remaining on your present loan. Fixed-rate
mortgages are typically available in five-year increments, with 15,
20 and 30-year mortgages the most common. You can get a 25-year
mortgage, but the rate may actually be a bit higher than you’d pay
on a 30-year loan.

What you can do instead, is to refinance into a 30-year
fixed-rate mortgage, and ask your lender to set up your payment
schedule so it will amortize in 25 years or however long you have
left on your current mortgage. That way, you realize the benefits
of a lower interest rate and still pay off the mortgage on the same
schedule.

Another possibility is to refinance into a shorter term
mortgage. Since 15- and 20-year fixed-rate mortgages have interest
rates that are significantly lower than 30-year loans (currently
about three-quarters of a percentage point difference between
30-year and 15-year loans), it can make sense to refinance into a
shorter term, even if it raises your monthly mortgage payment.
Again, an online mortgage calculator can help you figure exactly
what your new payments would be.

When did you last refinance?

Mortgage rates have fallen to new historic lows several times in
the past two years. This presents an often-overlooked hazard of
refinancing too often. Some homeowners, in their quest for
ever-lower interest rates, may fall into a trap of repeated
refinancing, piling up closing costs so that they make no progress
in actually paying down their mortgage – in fact, they’re
increasing their debt.

There’s no hard and fast rule on this – if a new refinance will
pay for itself during the time you plan to own the home, you will
save money, regardless of how recently you previously refinanced.
However, if it’s going to take you more than seven or eight years
to recover your closing costs, your savings may be so slight that
you might be better off waiting to see if rates go even lower, or
if they stay low long enough for you to pay down enough of your
balance to refinance into a shorter-term loan.

Also, you need to be aware that some mortgages have penalties
for prepayment, particularly if you pay them off within the first
year or two. If that’s the case with your mortgage, you want to be
sure you’re beyond that period before refinancing.

What’s your credit score?

Even with mortgage rates at historic lows, you might not be able
to take advantage of them if you’ve got blemished credit. Borrowers
with FICO credit scores in 680-700 range will likely pay nearly
half a percentage point more than those with “perfect” scores of
760 and above. Those with scores in the 620 range can expect to pay
rates more than 1.5 percentage points higher.

The good news is that credit scores can improve significantly
within a relatively short time, as long as you pay your bills on
time and don’t have a major blemish on your record, such as a
bankruptcy or 90-day delinquency. For lesser blemishes, most of the
impact on your credit goes away with two or three years, sometimes
even less, so you might consider waiting for your score to
recover.

What about a no-cost refinance?

A no-cost refinance is a bit misleading. You’re still paying
closing costs, they’re just rolled into the new loan in the form of
a higher interest rate. Generally, a no-cost refinance works to
your advantage if you’re not planning to stay in the home for a
long time – say five or six years or so. If you end up living in
the home another decade or more, it’s going to cost you money
because you’re paying a higher interest rate than you would have if
you just added the closing costs onto your loan balance.

This is where it pays to shop around. Obtain quotes from lenders
for no-cost and conventional refinances and use an online mortgage
calculator to see how the costs play out.

This are just some of the questions you’ll need to ask yourself
when considering a refinance, but they’re fundamental ones. Answer
them and you’ll have a pretty good grasp on whether a refinance at
this time makes sense for you.