What exactly is involved with a loan refinancing, and how do you know when to refinance a mortgage?

How Do You Know When to Refinance a Mortgage?

It’s a common strategy for homeowners everywhere: Refinancing their home loans to take advantage of savings opportunities. Sometimes people even refinance within months of their initial closing. What exactly is involved with a loan refinancing, and how do you know when to refinance a mortgage? Basically, it all boils down to when the numbers and your circumstances make sense. Here are things to consider.

First: Understanding refinancing

Refinancing simply means paying off an existing home loan and replacing it with a new one. In doing this, homeowners can take advantage of a new loan that has a lower interest rate, which can save them thousands of dollars over the course of their homeownership. They can also switch from a loan with an adjustable rate to one with a fixed rate, which can eliminate guesswork and anxiety about future mortgage payments. Or, they can switch to a loan with a shorter them, allowing them to pay off the loan sooner. They can also refinance to access some of the equity in their home to finance a large purchase or to consolidate debt.

Signs it’s a good time to refinance.

It can save you money. Mortgage refinancing is often triggered by drops in interest rates, which are in turn triggered by market factors. If you have good credit, you can take advantage of these drops and refinance your mortgage at a lower rate. If you can lock in at a new rate that is 2% -- or even 1% -- lower than what you’re paying now, you can significantly reduce your monthly payment.

Consider this: If you have a 30-year-fixed rate mortgage on a $100,000 home at an interest rate of 9%, your payments, including principal and interest, would be a little over $800 per month. But, if you were to refinance to a loan at 4.5% interest, your monthly payment would be a little over $500. And, at the same time, you’d be paying less in interest and thus building equity in your home faster.

Alternatively, you can also restructure at the lower rate for a shorter-term mortgage. For example, consider that same 30-year fixed-rate loan for $100,000 at 9%. If you refinance to a 15-year loan at 5.5%, the payment only increases by about $15 per month. While your mortgage payment is a little higher, you pay less interest on the loan over time, which can save you more money in the long run. In this case, you pay off your house twice as early!

Closing costs are manageable. As you’re considering savings through a lower interest rate, it’s also important to cover closing costs. Just like you had with your first mortgage costs are again required to refinance because you are in essence getting a second mortgage.

Closing costs vary based on your lender and where you live, but they generally range between 3% and 6% of your loan amount, and they cover costs associated with the:

• Loan application or origination fee to start the mortgage application process
• Loan underwriting fee that pays an underwriter to assess your ability to make the loan payments
• Home appraisal fee that banks use to determine the true value of your home and how much they can loan you
• Title insurance that covers any ownership issues that might arise on the original and new title
• Yield-spread premium if you use a mortgage broker
• Credit report fee to check your credit and make sure you’re in good standing.
• Discount points that you pay to the lender at closing for the reduced interest rate
• Prepayment penalty that a lender might charge if you’re going to be paying off the loan early.

These fees can get complicated and can quickly add up to upfront charges that may make the savings of a refinance not worth it. Some lenders advertise “no closings cost” or “zero closing costs” mortgages, but often those are in exchange for a higher rate. If your goal is to save money every month, skipping closing costs then won’t necessarily help. In evaluating refinance opportunities, it’s best to understand and factor in closing costs to your overall formula to see if the refinance still makes sense.

You’ve considered your situation. Finally, the decision of when to refinance a mortgage depends on your particular circumstance. Refinancing can be used to tap into equity you may need for healthcare, college tuition, or financial opportunities. It can also be used as a way to consolidate debt from high-interest credit cards, other loans, or even another mortgage. Debt can be wrapped up together into one convenient and often lower monthly payment if you get a good interest rate. An added bonus is that the interest you pay on mortgages is tax-deductible.

Refinancing is also a way to convert your current mortgage from an adjustable rate to fixed rate. Many people do this because it can alleviate surprises and fluctuations in mortgage payments. It’s also possible to convert a fixed-rate loan to an adjustable-rate mortgage. If your personal situation involves not staying in the home long, refinancing to an adjustable-rate mortgage when interest rates are low lets you take advantage of monthly savings. Then, if interest rates go back up, you likely won’t be in the home anymore and it won’t make a difference. Basically, you save in the short term, and you have no mortgage in the long term.

At some point of their homeownership, many people decide to refinance for a variety of reasons. It can be relatively simple, and it can open up doors to using your equity to achieve your goals. It’s a powerful resource and a way to finance the things you want and need without incurring credit card debt. As long as you know when to refinance a mortgage, it can be one of your best financial moves.