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4 key questions to ask now before you decide to refinance your mortgage

Key Points
  • Today borrowers can snag a 30-year mortgage for 3.81% and a 15-year loan for 3.16%, compared to 4.46% and 3.91%, respectively, just a year ago, according to Freddie Mac.
  • Before jumping into refinancing, ask yourself these four questions to decide if it makes sense for you.
Twenty20

With interest rates at near historic lows (again), refinancing might be on your radar, which means you may be able to swap out your old, higher interest rate for a new one with lower rates. But will that put you in a better financial situation?

Today borrowers can snag a 30-year mortgage for 3.81% and a 15-year loan for 3.16%, compared to 4.46% and 3.91%, respectively, just a year ago, according to Freddie Mac.

No wonder mortgage applications for refinancing a home have surged over the last year. At its last reading on Jan. 8, the Mortgage Bankers Association's Refinance Index, a measure of refinancing activity, was up 74% from a year earlier.

Many observers, like Keith Gumbinger, vice president of mortgage data company HSH.com, expect refinancing will stay elevated throughout 2020 but taper off as the year progresses and more borrowers take advantage of the low rate and are no longer interested in refinancing.

There are 8.1 million eligible borrowers for mortgage refinancing in the U.S., estimate Black Knight, a mortgage software and analytics company. The average borrower could save about $270 a month, bringing the total amount of potential savings to a stunning $2.19 trillion.

But refinancing is not a wise financial move for everyone. Before signing on the dotted line, ask yourself these four key questions to decide if it makes sense for you.

Question No.1: What are my goals?

Low interest rates alone aren't a reason to refinance. But depending on what you want to do, refinancing could be the answer.

For most people, the goal of refinancing is to lower monthly bills. Say you have a 30-year mortgage for $250,000 that you took out a year ago at 4.46%. That would bring your monthly payment to $1,260.78, according to the refinancing calculator at HSH.com. Refinancing would reduce that payment to $1,147.37. Better yet, you'll save more than $34,000 in interest over the life of the loan.

Or you could shorten the term of your loan by opting for a 15-year loan instead, becoming mortgage-free several years sooner.

"By going from a 30-year to a 15, you might be cutting total interest costs by half," said Mari Adam, CFP and founder and president of Adam Financial Associates in Boca Raton, Florida.

But tread carefully, Adam cautioned. In all likelihood, given the compressed time frame, your monthly payment will go up. For example, on a $250,000 loan at 3.16%, monthly payments would be $1,745.76 for the 15-year mortgage. "Math-wise that looks like a great idea, but sometimes people overestimate their ability to make that higher payment, then something goes wrong and they're struggling to make it."

Finally, anyone with an adjustable-rate mortgage should seize the opportunity to lock in low rates. Though the Fed has indicated that it doesn't plan to raise rates anytime soon, there's little reason to think that rates will fall much lower.

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"If you have an adjustable-rate mortgage, you've been lucky that rates haven't gone up, but it comes with uncertainty," said Adam.

Question No. 2: Is refinancing worth the cost?

To determine how much value you can get from refinancing, do some simple math.

Anticipate closing costs to run about 2% to 4% of total loan value. These include things like appraisal, underwriting and title. So if your closing costs are $3,000 and you can save $200 a month by refinancing, it will take 15 months to break even.

"If you stay in your home longer than that, that's a good indication that you're going to get a lot of value out of this refi," said Kevin Parker, vice president of field mortgage originations at Navy Federal Credit Union.

But if your savings are more modest, say just $50 a month, then it will take 60 months — or five years — to recoup. Even if you have no intention of moving today, a lot can happen in five years.

Question No. 3: Can I afford the closing costs?

Lenders love to tout low-cost or no-cost refinancing. But make no mistake; you pay for refinancing.

One option, and the one recommended by most financial advisors, is to pay these costs upfront. Another is to roll them up into your loan, but it makes the loan amount higher and will take longer to break even.

The third is a "no-cost" refinance, which doesn't charge closing costs but instead comes with an interest rate that could be as much as half a percentage point higher, according to HSH.com. You can see how the three options stack up with the HSH.com calculator.

"Paying cash for your closing costs means never having to worry about higher payments down the line," said Gumbinger of HSH.com.

Diane Pearson of Pearson Financial Planning, a fee-only planner in Pittsburgh, recommends asking your existing lender for a break on closing costs. "They know you and are comfortable with you," she said. "They want to keep your business." Pearson acknowledges this strategy might be easier to pull off with a local credit union than a large, national bank.

Question No. 4: What are the refinancing pitfalls?

Like anything, refinancing has its downsides.

Take "cash out" refinancing, which lets you refinance the remaining amount of your mortgage in addition to more money, provided you have enough equity in your home. Financial advisors are split on whether this a good idea, depending on what you want to do with the money.

"If you're using the money for something like remodeling, you're potentially increasing value of that asset," said Pearson.

But using your home equity to pay down credit cards or other type of unsecured debt is something else. True, converting debt that might cost 18% in interest to a loan that charges less than 4% looks good on paper. If you're prone to credit card debt, refinancing could magnify the problem.

"You need to understand that you're taking debt that could potentially be discharged, and instead you're putting it on your house, where you could lose your house if you don't pay back your mortgage," said Adam.

Finally, remember that refinancing adds more years to your loan. A 30-year mortgage could quickly turn into a 40- or 45-year loan through refinancing. And because of the way amortization schedules work, the bulk of a mortgage's interest is paid at the beginning of a loan. Starting the clock again means you'll spend years paying off interest before making serious inroads on principal.

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