The decision to refinance a mortgage varies from case to case. Many factors interfere in making the decision, including how long you will live in the property or the interest rates. In some cases, refinancing is the right decision, but in other cases, it will be a financial loss.
Homeowners are often encouraged to refinance mortgages when interest rates are low. Experts in the field recommend refinancing credit to save money while taking advantage of low fees. But if you doubt the ideal time, the rule of thumb states when to refinance a mortgage.
When to refinance a mortgage, according to the rule of thumb
Financial and real estate experts say that in some cases, it is an idea to refinance the mortgage; the most important question is, at what point is it worth it to refinance? There is no exact annual date where this procedure is beneficial, but it depends on the factors that the market announces.
The most important stimulus to consider is low-interest rates. When facing this process, the general rule of thumb indicates that refinancing a mortgage is recommended when interest payments are at least 1% lower than current rates. The lower the payment, the greater the savings potential.
Why refinance your mortgage with the 1% rule?
Using 1% as a rule of thumb to define when to refinance a mortgage allows you to save thousands of dollars per year. For example, a client has a $500,000 loan and applies for 1% refinancing. With this new agreement, he would save $280 per month and $3,360 per year.
When interest rates go down, homeowners think about refinancing, but the ability to save will be greater when the interest payment is less than the current amount. In another example, a client pays 5.5% in interest, but when refinancing to 5%, the amount changes as follows:
- 5.5%: monthly payment of $1,136
- 5%: monthly payment of $1,074
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- 5.5%: monthly savings of $63
- 5%: monthly savings of $125
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- 5.5%: annual savings of $756
- 5%: annual savings of $1,500
It is important to clarify that not all these savings end up in your pocket. You must also include the refinancing payment, closing costs, and prepayment penalties. Closing costs are standard at $5,000. Refinancing at less than one percent would not be worth it if you assume these bills.
Other factors to consider before refinancing a mortgage
The 1% rule only considers low-interest rates as an indicator for refinancing a mortgage, but you should also consider the following aspects:
Goal for refinancing
If your goal is to lower your monthly payment, you should consider the terms of your new loan. For example, lower monthly payments may mean that the time to pay the mortgage becomes longer; that is, it allows you to save money per month but increases your debt for another few years.
In this first installment, we invite you to meditate on your real goals with this debt. If you want to save monthly, refinancing is a great option, but if you want to reduce your years of debt, it is not as convenient.
Take into account the type of loan you have
If you have an Adjustable Rate Mortgage (ARM), you can benefit from the interest rate drop without having to refinance. ARMs have a fixed rate period with lower interest rates than at the beginning of the mortgage. If the time is coming to an end and the adjusted interest rate will be higher than if you refinance a fixed-rate mortgage, it is wise to switch.
If you have a Fixed Rate Mortgage and interest rates continue to drop, switching to an ARM will allow you to take advantage of the drop over time without refinancing.
Consider your credit score
Your credit record is critical to whether or not you can refinance a mortgage. If you had great points when you got the loan but missed payments on your credit card, your credit score must have gone down. The rule states that if your credit score is worse than when you got the mortgage, you will not be able to access the previously available loans.
You will probably end up paying more for any mortgage you refinance. Conversely, if your credit score has improved since you received the loan, you are eligible for better rates and more beneficial terms.
What is the number one downfall to refinancing your home?
As we have seen above, refinancing a mortgage payment is not always the best option. In addition to the “factors to consider,” you should also take into account certain personal situations that will help determine when it’s a good idea to refinance the loan:
First choice: You don’t plan to stay in that home for very long
The homeowner needs to know how long it will take to recoup the new loan payment. This is called the break-even period, after which you start saving money on your new mortgage. For this, it is important to determine the closing cost and the new loan’s interest rate to calculate the balance.
Refinancing the home is not a good idea if you want to move out of the property before the end of the break-even period.
Second option: You can’t afford the closing costs
It’s not a good idea if you can’t pay the closing cost out of pocket. In this case, you can also go with the option that adds the closing cost to your debt and pay it by the month. But consider that your monthly payments will be higher and you won’t be able to save.
Third Option: Higher Long-Term Costs
Consider the long-term cost of refinancing. Refinancing a mortgage in the short term will cause your monthly payments to increase and make it unaffordable for you. Long-term refinancing will make lower monthly payments, but you will gain more years of debt.