You don't always get do-overs in life, but when it comes to mortgages, you can often refinance your current loan into another one. Doing so can shrink your interest rate, lower your monthly payments, or achieve other goals. Luckily, this is a promising time to refinance, as interest rates remain near historic lows.
Just be sure not to commit any big blunders when refinancing, lest you end up with a smaller financial benefit. Here's a quick look at some common mortgage financing mistakes to avoid.
Mistake No. 1: Refinancing when it doesn't make sense
A key error to avoid is refinancing when you're not in a position to do so effectively. For example, a rough rule of thumb is that there should be a difference in interest rates between your old loan and your new one of at least 1 percentage point. (Have a 30-year loan at 5% and want to refinance into a 4.5% 30-year loan? It probably won't be worth it.) Run the numbers to be sure, though. Rates change all the time, but the national average interest rate for a 30-year fixed-rate mortgage was recently 4.24% (up from 3.75% a year earlier).
Also, know that if you don't have 20% equity in your home or if you're carrying a lot of debt, refinancing may not work or be worthwhile. Having less than 20% (which could happen even if you originally paid 20% down, if your home's value has fallen) will likely lead to your lender requiring you to buy private mortgage insurance (or PMI), adding to the expense of paying for your home. Similarly, your debt-to-income ratio may have been fine when you originally bought your house, but if you have since taken on more debt, you may be a less promising borrower today. If so, it could be worth spending a little time paying down your debt before refinancing.
Mistake No. 2: Focusing on APYs instead of APRs
When shopping around and comparing mortgage interest rates, don't just look at annual percentage yields (APYs). Instead, pay more attention to quoted annual percentage rates (APRs), which will more accurately reflect what you'll be paying by incorporating expenses such as closing costs.
Mistake No. 3: Ignoring a bad credit score
Next, remember that if you want to be offered the lowest interest rate you can get, you'll need a high credit score. If your score isn't strong, spend some time looking into how you might raise your score, such as by correcting errors in your credit report, paying down debt, and paying bills on time. The table below shows what kind of difference a strong score can make. It reflects recent interest rates for someone borrowing $200,000 via a 30-year fixed-rate mortgage and makes clear how much you might save by boosting your score.
Total Interest Paid
Mistake No. 4: Falling for a "no-cost" refinancing
When looking into refinancing, be wary of a "no-cost" refinancing offer. Refinancings, like original mortgages, have closing costs -- and you'll either pay them up front or they'll be conveniently tacked onto your loan amount -- which can increase your interest rate. It's usually best to pay the costs up front. (If you're not planning to stay in the home long, though, it can be worth folding the closing costs into the loan, as you won't be dealing with the higher interest rate for too long.)
Mistake No. 5: Refinancing into the wrong kind of mortgage
This is a critical consideration. If you're going to the trouble and expense of refinancing, make sure your new loan will serve you well. For example, if you started out with an adjustable-rate mortgage (ARM), you may be facing gradually increasing interest rates over the coming years -- which will cost you more and more. You could refinance into a fixed-rate loan, locking in a low rate.
Alternatively, you might switch from a 30-year fixed-rate loan into a 15-year fixed-rate loan, in order to pay the loan off sooner and pay less in interest. It will entail higher monthly payments, though, so be sure you can swing those. If you're not sure you can, here's a handy compromise: Get a 30-year loan with no prepayment penalty, and then pay more than your required payment each month. That way, you can shave years off the loan and avoid a lot of interest payments. If you're getting pre-approved for a mortgage or a refinancing, make sure that your new loan doesn't include a prepayment penalty. If you're already in a 30-year mortgage with no prepayment penalty, you may not need to refinance at all -- you can shorten the life of your loan by just plowing more money into paying down your principal.
Mistake No. 6: Not calculating your breakeven point
Don't forget to calculate your breakeven point to see whether refinancing will be worth it. For example, if your closing costs are $6,000 and you're saving $100 per month by refinancing, divide $6,000 by $100 and you'll get 60. That means it will take 60 months (five years) before you'll break even. That's no problem if you expect to be in the home at least that long. But if you might be moving sooner than that, refinancing might not be a smart move.
Mistake No. 7: Taking cash out when you refinance
Finally, resist the temptation to take cash out when you refinance -- unless you really need to. Here's how that works: Imagine that your home is worth about $400,000. If you currently owe $250,000 on it and have $150,000 in home equity, you might refinance into a new $300,000 loan, keeping about $50,000 in cash. The cash is nice -- and with current low interest rates, it's an inexpensive way to borrow money -- but you've now set yourself up with a bigger mortgage (that will probably last longer, if you opted for a 30-year loan) and you have less home equity. Think carefully about whether it's worth it. If you're going to use the cash to pay off high-interest rate credit card debt, it can be a smart money move. But be sure you have the discipline to use the money for that. Don't treat it as a windfall. Know, too, that cash-out refinancings can carry higher interest rates than ones without cash-outs.
Refinancing your mortgage can be a savvy financial move that can save you a lot of money. But if you make some of the mistakes above, you might save a lot less -- or you might even lose money. Be an informed and prepared refinancer.
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