(Photo credit: Shutterstock)With mortgage interest rates bottoming out at a little more than 3 percent for a 30-year fixed-rate mortgage, homeowners are rushing to refinance — and with good reason. But not every refinance makes financial sense.
Some refinances won't save you enough money to make it worthwhile in the short run, and others might wind up costing you in the long term. If you're going to refinance, there are a few things — such as the length of the loan, closing costs, and the difference in interest rates — to keep in mind to make the most of your refinance opportunity.
Should you refinance?
There are plenty of rules of thumb floating around that purport to tell you whether or not you should refinance. Rules of thumb can be helpful, but almost misleading. Here's a good one: Typically, if you can recoup all your closing costs within two years, but ideally within six months to a year, your refinance could be worth it. If your interest rate will drop by at least 1 percent, but ideally 2 percent, you should also strongly consider refinancing.
But these are just general rules in a world ruled by individualized factors — they might not apply if your loan is bigger or you're planning to move in the next three years.
One of the most important things to monitor is how your credit score has changed since you initially took on the loan. Risk-based pricing can make a major difference in how much money you will save on a refinance, said Frank Donnelly, president of the Mortgage Bankers Association of metropolitan Washington.
In one case, Donnelly saw a major difference just a single point in a credit score can make.
"Let's say Mr. Jones has a 719 [credit score] and Mrs. Jones has a 720. That adds three-quarters of a point to their mortgage, and that's $2,250," Donnelly said. "That's only the difference between 719 and a 720. If you have a 620, you may be able to refinance, but your risk premium is going to be so high the low rates won't matter because there are tons of closing costs."
And if your mortgage is underwater, there may be little help for you at all, despite a sterling credit record. Yet Donnelly has seen cases of people borrowing from their 401(k) to get the money required to put them above water, then refinancing. The move, known as a "cash-in" refinance because you're putting cash in to make the deal go through, can be a risky move, but if you negotiate your refinance correctly, you can still save money over the long run.
The ideal refinance
There are a lot of ways your refinance can go wrong, but if you can incorporate these four key questions, you'll undoubtedly wind up with what I call a "home-run refinance":
1. Can you lower the interest rate on your mortgage?
2. Can you lower your monthly payment?
3. Can you shorten the loan term?
4. And, can you pay off the costs of the refinance in a year or less from the monthly savings?
While it is difficult to incorporate all four questions into your refinance equation, you should strive to do so. Typically, you'll find that a significant reduction in the interest rate or loan term will allow you to make the most of your refinance.
Of course, if you can't get to yes with all four questions, focus on shortening your loan term. Reducing the length of the loan will save you the most money in interest over the long term.
For example, if you took out a $250,000 refinance loan at 5 percent for 30 years, you'll pay almost $230,000 in interest over the life of the loan. But shave five years off that same loan and you'll save nearly $45,000.
Don't feel the need to snap up the newest, lowest interest rate if the move isn't right. Historic lows are still being set and interest rates are likely to remain low for a long time — years, even. Wait for the right time and look for more creative solutions to give you what you want.
"I knew one couple, both doctors — one was a physician and one PhD. Both traveled a lot and had tons of money, but their credit scores weren't that good," Donnelly said. "A refinance would save them $100 a month but cost them 3 points or $9,000, and that didn't make sense. We waited a while and put some money in upfront and paid down part of the loan. Not everyone can do that, but it worked."