With the Federal Reserve doing everything it can to keep interest rates low in the United States, mortgage rates have reached historic lows week after week. If you are a current homeowner the dropping rates could potentially save you thousands of dollars over the life of your loan. It is smart to look at your mortgage refinancing options to determine whether or not refinancing is a financial move you should make right now. But how do you know when you should refinance your mortgage?

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Determining When to Refinance

When You Have >20% Equity

As cheap as mortgage rates have become, there is not much you can do to refinance your home if you do not have enough equity in your home. With new lending standards impacting the ability of loan officers to get your loan through underwriting, the days of 100% financing are gone.

The easiest path to refinancing your home is to have at least 20% equity in your home. That would put your loan-to-value (LTV) at 80%, which is a standard for new and refinanced mortgages. If your loan-to-value is higher than 80% you can still see if you have the option to refinance your home, but the odds are much slimmer with less equity in your home than 20%.

When There Are Significant Difference in Rates

If you just bought a home and financed the purchase with a 4.5% mortgage, you already have a great rate. If you refinanced to a 3.75% rate you would, eventually, save money on the mortgage, but it would take years to make up for the closing costs.

A common rule of thumb is to refinance when the new rate you can get on the refinanced mortgage is more than 1% different than your current mortgage. If you have a 5% mortgage and could refinance into a 4% mortgage, it probably makes sense to move forward.

When You Plan to Live in Your Home for a Long Time

A critical piece of refinancing that many people miss is the time it will take you to payback the closing costs on the refinanced mortgage. Dropping your interest rate is almost always a good thing, but if you pay $2,000 in closing costs to refinance today and sell the home in 12 months, you’ve lost a lot of money.

This mirrors the decision to buy a home in the first place. If you aren’t going to live in the home for more than 5 to 10 years, it doesn’t make much sense to purchase today. You would be better off renting because of the costs incurred with buying the home (closing costs, maintenance) and selling the home (closing costs, lost equity, and realtor commission) wipe out any growth in the value of the home.

Calculating the Refinance Payback Period

To best know if refinancing makes sense for your situation, do the math. There are many online mortgage calculators available to show you when to refinance, but the math is usually simple enough to handle on your own.

What You Need:

  • your current mortgage payment and interest rate
  • your remaining balance
  • the new refinanced rate you would have (and length of refinanced mortgage)
  • estimated closing costs

If your current payment is $783 per month on a 4.75% mortgage and refinancing to a new rate of 4.25% would drop your payment by $45 (to $738), how long would it take you to pay off the closing costs? If your closing costs are $2,000 it would take you a little more than 44 months (or 3 years, 8 months) for the difference in your payment to make up for the closing costs. If you sold your home at the 4 year mark you would only benefit 4 months worth of savings — only $180. You would need to plan to live in the home much longer to justify refinancing.

Have you been thinking about refinancing your loan? Does this article help you make up your mind? Please tell us your story.

Photo by alancleaver.