Refinancing your mortgage is a big financial decision that can save you a lot of money and free up equity in your home. But it’s not always the best decision in the moment, so when is the best time to refinance your mortgage? A lot of it depends on interest rates, how long you’ve owned your home, how long you plan to stay, and your reasons for refinancing.
What Is Refinancing?
Refinancing means replacing your current mortgage loan with a new one, optimally with more favorable terms. In effect, you use your new loan to pay off your old mortgage, and you start fresh. The approval process for refinancing is similar to the process for getting a new one, so you’ll need to be prepared for paperwork, closing costs, and a new appraisal.
When Refinancing Makes Clear Sense
There are a few clear indicators that now is a good time to refinance:
Interest Rates Are at Least 1% Lower
A traditional rule of thumb is to refinance when you can reduce your mortgage rate by at least 1%. Here’s how a rate reduction can affect your monthly costs: on a $300,000 mortgage, dropping from 6% to 5% saves you about $175 per month, or $2100 per year. Over the course of a 30-year loan, that’s a total of $63,000 in savings.
You Can Eliminate Your Private Mortgage Insurance (PMI)
If you bought your house with less than 20% down, you’re probably paying PMI. This is typically $30 to $70 per month for every $100,000 borrowed, or $900 to $2100 on a $300,000 loan.
If you’re paying PMI, the best time to refinance is when you’ve built 20% equity in your home. Even if the new interest rate is the same as your current rate, removing PMI might justify refinancing. For example, if your PMI is $150 per month and your refinancing costs would be $6000, you’ll break even in 40 months. After that, you’ll save $1800 annually.
You’re Converting from an Adjustable-Rate Mortgage (ARM) to a Fixed-rate Mortgage.
The best time to refinance your mortgage and switch from an ARM to a fixed rate is when:
- The ARM’s fixed-rate period is ending.
- You want the certainty and stability of knowing what your payments will be every month.
- It would be hard for you to absorb a payment increase if your ARM rate goes up.
- Rates are historically low.
- The economic outlook is uncertain, and you’re risk-averse.
If you do decide to lock into a fixed-rate loan and rates subsequently drop, you can always refinance again if the numbers make sense.
You’re Converting from a Fixed-rate to an Adjustable-Rate Mortgage
The best time to refinance your mortgage and switch from a fixed-rate loan to an ARM is when:
- You know you’ll be moving within three to five years; ARMs typically have lower initial rates, so you’ll save money without significant risk.
- You expect rates to drop in the coming few years, allowing you to benefit from falling rates automatically without paying refinancing costs.
- The rate difference between an ARM and a fixed-rate mortgage is substantial (over 1.5%).
- You plan to pay your mortgage off early, before the ARM’s fixed rate period is over.
You Want to Shorten Your Loan Term
Refinancing from a 30-year mortgage to a 15-year mortgage dramatically reduces the total interest you’ll pay over the loan’s life, and it leaves you mortgage-free much earlier. This strategy makes sense if your financial situation has changed substantially since you got your mortgage, but it’s not for everyone. The best time to refinance a mortgage for a shorter term is when the higher payments are comfortable for you and leave you room for your other expenses.
Here’s how much you could save with a shorter term: on a $300,000 mortgage at 6% you’ll pay approximately $347,000 in interest over 30 years. Refinancing to a 15-year mortgage at 5.5% means paying roughly $137,000 in interest, saving you $210,000.
You Want to Access Your Home Equity
If you’ve built up substantial equity in your home and you want funds for home improvements, debt consolidation, or other major costs, cash-out refinancing lets you tap into that equity. If you can also secure better mortgage terms in the process, it’s a win-win.
Keep in mind that you’ll need to pay closing costs
On the refinance, do the calculations to make sure it’s worth it, especially if you’re using the cash-out refinance for a consolidation loan.
When It Makes Sense to Wait Rather Than Refinancing Now
In some situations, it’s better to delay refinancing.
You Purchased Your Home Recently
If you purchased your home or you refinanced your mortgage within the last 2 to 3 years, you probably haven’t recouped the closing costs from your original mortgage application. If that’s the case, it’s not the best time to refinance your mortgage. Wait until you’ve reached the break-even point on your current loan (usually 3 to 5 years), unless there’s a dramatic interest rate drop.
You’re Planning to Sell
If you’re planning to move before reaching the break-even point on closing costs, now is not the time to refinance. Let’s say refinancing saves you $150 a month, but refinancing costs you $7500. If you sell in three years (36 months), you’ll have paid $7,500 in costs but only saved $5,400 in payments, meaning that you’ll have lost $2,100 on the refinance.
Your Credit Score Has Dropped, or Your Debt-to-income Ratio (DTI) Has Increased
Your mortgage rate is heavily influenced by your credit score and DTI. If either of these financial metrics has changed, work to improve them before starting the refinancing process.
Your Home Value Has Dropped
If your home value has dropped due to market conditions, refinancing will be more difficult. Lenders typically require 20% equity for conventional refinancing and more for cash-out refinancing, so if your equity has fallen below that, you may not qualify for a new loan.
If, for example, you owe $250,000 on your mortgage, but your home is now worth only $280,000, you have just 10.7% equity in the home, insufficient for most refinancing applications. The best time to refinance your mortgage will be when you’ve paid the mortgage down or when home values recover.
Your Income or Employment Has Changed
If you’ve recently changed jobs, become self-employed, or had a reduction in income, you might not qualify for refinancing at this time. Lenders usually want to see stable employment in the same field and consistent employment. Wait with refinancing until you’ve established a longer employment record.
Running the Numbers
If you’re trying to decide the best time to refinance your mortgage, go with the hard numbers:
- Calculate your potential monthly savings using an online mortgage calculator.
- Determine your total closing cost by getting loan estimates from multiple lenders.
- Find your break-even point: divide your total closing cost by your monthly savings. You’ll need to stay in the home at least until your break-even point.
- Calculate the total interest over the life of the loan to see if a shorter term makes sense.
- Factor in any tax implications.
Making a refinancing decision can be complex, especially when you consider opportunity costs. If you’re struggling with the decision, consult with your financial planner for a more objective opinion.
