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Is Refinancing Right for You?

Refinancing is a hot topic because interest rates are still historically low. It can save on your mortgage costs and even improve your credit rating.

The key is understanding if refinancing is right for you.

For our examples, we’ll assume the original loan was for $200,000 for a house worth $240,000. The loan is for 30 years at 6.5 percent interest.

What is my target interest rate?

Conventional wisdom says the new interest rate has to be at least 1 percent lower than your current rate for you to evaluate refinancing and 2 percent lower for refinancing to make sense.

In our scenario, a mortgage with a 4.5 percent interest rate would reduce your monthly payment by $250. A rate of 5.5 percent would save you about $130 per month.

Interest

Loan Term

Monthly Payment

Monthly Savings

6.5% (original) 30 years $1,264.14  
5.5% 30 years $1,135.58 $128.56
4.5% 30 years $1,013.37 $250.77

Do your own calculations using the Pinnacle mortgage calculator.

Interest rates are important because they will help you answer the question…

How long will it take to recoup my closing costs?

Refinancing includes the same costs, e.g. attorney fees, appraisal costs, title insurance, etc., as when you purchased the house originally. Closing costs typically range 3 to 5 percent, not including any discount mortgage points.

Below is an example with a 4.5 percent cost on a $200,000 loan:

Refinance Interest Rate

Closing Costs

Months to Recoup

Years to Recoup

5.5% $8,000 65 5.4
4.5% $8,000 31.9 2.6

The rule of thumb is it takes four to six years to recoup your closing costs. You can’t recoup your closing costs when you sell your home, and people move on average every five years. Think strongly about refinancing if your time to recoup is three years or less. Consider refinancing if you can recoup in four to six years. If the time is longer than six years, your decision will rest on how long you intend to stay in the house.

Can I refinance if the value of my home has fallen?

It depends. Banks evaluate loans based on the loan-to-value (LTV) ratio. You calculate LTV by dividing the loan by the value of the house. Most banks will not write a loan if the LTV is higher than 90 percent.

In our scenario, you would a have difficult time refinancing if the value of the house dropped as little as $20,000. Here’s why.

The house is now worth $220,000. The amount you need to refinance remains close to the original $200,000. The LTV for the house originally was 80 percent. It’s now increased to 90 percent because of the decrease in the house value. The higher LTV will make the loan much harder to secure.

Should I take advantage of a “no cost” refinance?

No cost does not translate to free. The people who sell these mortgages eliminate (or significantly lower) the closing costs to entice people into refinancing. The lender will simply roll these fees into the total loan amount.

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