If you're considering refinancing your home, it's probably because you think you can save money - especially now, when interest rates are at an all-time low.
Well, your thinking is right on target.
There are many ways to save money through refinancing - including lowering your interest rate and shortening the term of your loan. But unfortunately, with refinancing fees, there are just as many ways to lose money when you refinance.
So, how can you tell if you'll actually save money by refinancing?
Consider this advice: "Refinancing a current mortgage is a personal decision that should be based upon not only current monthly savings but also your short and long term plans," says Rod Zacharias, a Boise, Idaho mortgage broker.
To determine if refinancing is right for you, read on to learn more about how you can save - and lose - money by refinancing.
Ways You Can Save Money by Refinancing
#1 - Getting a Lower Interest Rate
In general, refinancing for a lower interest rate is probably going to save you money, both on a monthly basis and over the term of your loan.
How? Consider this example from a refinancing guide published by the Federal Reserve System, which oversees national monetary policy and banks. The example shows how you can save money with just a slightly lower interest rate on a 30-year fixed-rate loan of $200,000:
|Monthly payment @ 6.0 percent:||$1,199|
|Monthly payment @ 5.5 percent:||$1,136|
|Difference each month:||$63|
|Difference over a year's time:||$756|
|Savings over 10 years:||$7,560|
Now that's a good chunk of savings for just a .5 percent drop in interest rates, isn't it?
However, there are a few caveats. Even with a lower interest rate, Zacharias says borrowers need to consider closing costs (fees paid for a real estate transaction) and make sure the savings from the lower interest rate will outweigh the refinancing costs.
#2 - Switching to a Shorter-Term Loan
When paying off a longer-term loan, you might feel like you're saving money because your monthly payments are low. However, according to the Federal Reserve, you can save money in interest by paying that same loan off over a shorter term.
And that's not all. "Mortgage interest rates can be less on a 15-year loan, saving you additional money over what you've already saved by shortening the term of the loan," says California mortgage professional and real estate consultant, Shari Downend.
Just how much can you save? Let's take a look at an example from the Federal Reserve, which compares the total interest on a 15-year fixed-rate loan versus a 30-year fixed-rate loan of $200,000:
|Monthly Payment||Total Interest|
|15-year loan @ 5.5 percent||$1,634||$ 94,120|
|30-year loan @ 6.0 percent||$1,199||$231,640|
As you can see, refinancing to a shorter-term mortgage is a very effective way to save thousands of dollars.
But before you take this step, Zacharias offers this warning: "Refinancing to a shorter term-loan with a lower interest rate would only be advisable for a borrower if they're comfortable with the higher payment."
#3 - Switching From an Adjustable-Rate (ARM) to a Fixed-Rate Mortgage (FRM)
When you have an adjustable-rate mortgage (ARM), your payments fluctuate as interest rates go up and down, based on a market index. This can be great when interest rates are low, but brutal to your wallet when interest rates rise, and in effect, payments increase.
If you're uncomfortable with the idea of your payments going up, the Federal Reserve says that "you may want to consider switching to a fixed-rate mortgage to give yourself some peace of mind by having a steady interest rate and monthly payment. You also might prefer a fixed-rate mortgage if you think interest rates will be increasing in the future."
Zacharias agrees. He notes that with interest rates currently at historic lows, borrowers with an ARM may decide they want the security of staying with a low interest rate and a predictable payment.
As a final note on this topic, here's something to mull over: With rates currently at historic lows, do you think they could go any lower? If you do, then stick with an ARM. If you don't, then an FRM is the best money-saving option for you.
Ways You Can Lose Money by Refinancing
#1 - Refinancing Costs
Refinancing your loan doesn't come for free - not even close. It's actually a bit on the pricey side.
In fact, according to the Federal Reserve, refinancing can cost anywhere from 3 to 6 percent of the value of your loan, and could include applications fees, attorney fees, and prepayment penalties.
Now, 3 to 6 percent in fees isn't cheap, and these fees could override any savings - depending on the terms of your new refinanced loan, of course.
For this reason, however, Zacharias advises all refinancing candidates to comparison shop when it comes to loan fees. "Lenders want your business," says Zacharias. "If they know you're shopping for the best deal, they're going to make sure the pencil is very sharp at their end."
#2 - Moving Too Soon After Refinancing
Instant gratification is great, isn't it? Well, if you think that's what you're getting when you refinance, think again. It can take awhile for refinancing savings to kick in, thanks to those annoying refinancing costs we just mentioned.
Perhaps that's why the Federal Reserve suggests that you figure out your "breakeven point", which is when your closing costs have been recovered by your monthly savings. After your breakeven point, then your payments are truly going towards paying down your loan.
So, if you decide to sell your home before getting to the breakeven point, you haven't actually saved any money at all. In fact, you would have lost money.
"Borrowers who refinance every two years or so need to make sure the benefits far outweigh the costs," says Zacharias. He adds that a good rule of thumb is to achieve a two-to-three year breakeven point through your refinance and then stay in your home for several more years in order to reap the refinancing savings.
#3 - Choosing a Cash-out Refinancing
Are you thinking about refinancing your mortgage at an amount greater than what you owe on your home, so you can receive the difference in a cash payment? Also known as a cash-out refinancing, this may be an option you're considering if you want to pay off a car loan or a your child's college tuition.
However, a cash-out refinancing could lose you money. How? Because a home loan extends for a long period of time, and as a result, you could end up paying more in total interest than you would have if you'd paid down your short term debt another way.
In fact, "Many financial advisers caution against cash-out refinancing to pay down unsecured debt (such as credit cards) or short-term secured debt (such as car loans)," notes the Federal Reserve. "You may want to talk with a trusted financial adviser before you choose cash-out refinancing as a debt-consolidation plan."
Zacharias agrees. "Tapping into your home equity to pay off short-term debt usually isn't the best financial advice."
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