How do I know when it's time to refinance?

Q: How do I know when it's time to refinance?

A: When mortgage rates are low or falling, many homeowners question whether or not they should be applying for a new home loan. Traditionally, financial experts told homeowners to refinance when mortgage rates dropped two percentage points below their current rate.

Today, those old rules no longer apply. Some homeowners have opted to refinance their home loans when mortgage rates declined by as little as one-half percent from their current rate. Moreover, the decision to refinance should be based on a variety of factors in addition to mortgage rates, including costs, how long you've already been in your mortgage, how long you plan on being in your home and whether or not your needs, your qualifications and the market's offerings are in alignment.

To know when it's time to refinance, there are questions you'll need to answer and steps you'll need to take.

Define your refinancing goal

Since refinancing isn't without cost or inconvenience, if you're looking to recast what is probably your largest debt, you need to have a good reason. As such, you need to first define the reason why you are refinancing and the outcome you hope to achieve. Some common refinancing goals include:

• Lowering monthly payments
• Taking equity out of the home
• Changing the mortgage term
• Eliminating mortgage insurance

There can be other reasons, too, such as getting a former spouse's name off the mortgage, moving from a jumbo mortgage to a conforming one and others.

Whatever your goal, you need to define it, and then see if market conditions support your ability to achieve it. Just because you hear that mortgage rates in the market are low (or even at record lows) doesn't mean that these will necessarily be available for your situation or qualifications.

Refinancing considerations

The most common goal for refinancing is to attain a lower monthly payment.

Most frequently, this occurs by getting a new loan with a lower interest rate. But in addition to a lower rate, one overlooked contributor to getting a lower monthly payment is that the loan amount you're refinancing (and on which monthly payments are based) is smaller than the loan you're replacing and the restart of the loan over a new 30-year term. With a smaller loan amount, for example, it's possible to get a lower monthly payment even if the interest rate on the new loan remains the same! It the intersection of these three items -- lower rate, smaller loan amount and re-starting the term -- that matter greatly as to whether your lower payment results only in cash-flow improvements for a while or whether you can achieve both lower costs each month and actual savings overall.

To get started, you should develop a sense of how long you intend to stay in your home... or in this new mortgage. Refinancing costs money, so at a minimum you'll generally want to make sure you will at least recoup your closing costs.

The simplest calculation is to figure this out is to divide the difference in monthly payment from your existing loan compared to one on a potential new loan (e.g., $100) into an expected amount of closing costs (e.g., $2,000) to find your break-even point. In this example, it would be 20 months.

But getting your money back is only one consideration; you probably want to try to least get some return for your time and effort. As well, you need to be aware of the longer-term costs of your refinance, too. Use HSH.com's Should I Refinance?" calculator to run the numbers, learn your refinance break even point and find out whether or not your refinance will actually save you money.

Of course, when you refinance, you can't simply disregard the interest you have already paid on the loan you now have. Since you'll probably be re-starting with a new 30-year term again, you're technically also extending your loan repayment period. For example, if you've already paid off seven years of a 30-year mortgage and refinance into a new 30-year mortgage, you may be paying for your home for a total of 37 years, which means seven extra years of interest payments. Those additional years of interest cost may wipe out any savings from refinancing even with a lower monthly payment. HSH's "Should I Refinance?" calculator also takes this into account for you.

How will you pay refinance closing costs?

Like your purchase-money mortgage, your refinance will see you pay loan closing costs all over again. How you choose to pay them can determine if your refinance produces larger or smaller savings over time. You can pay fees out of pocket, but if you have enough equity in your home, you may be able to use some of it to pay these fees and end up with a slightly higher loan amount. Alternatively, you can have the lender pay them in exchange for a slightly higher interest rate (a "no-cost" refinance)-- but this can diminish or even eliminate refinance savings over time.

Depending on your situation and hoped-for outcome, you may have all three options open to you or none. If you don't have cash to spend (or don't wish to spend it) a higher loan balance may be available if you have equity to use, which would keep the interest rate the same, or else you'll need to accept a smaller interest rate break on the new loan. Each of these choices has benefits and drawbacks and different short and long-run cost profiles.

For example, a "no-cost" refinance may give you a lesser break on your monthly payment, but as there is no break-even cost-recovery period, paying fees in this way may save you money even if you have plans to sell your home relatively soon. That said, the higher-than-market interest rate you'll receive could make the gap between your old and new rate so small that the cash-flow improvement might not be worth the effort to refinance in the first place. Before you choose a method of paying refinance closing costs, you'll want to use HSH's Tri-Refi refinance calculator to see comparisons of costs and savings of each method over time.

How well are you aligned with today's mortgage underwriting standards?

It's not a secret that today's lowest mortgage rates are available only to those with the highest credit score, complete income and asset documentation, low debt loads, larger equity stakes and more.

If you don't have a great credit score, the new loan's interest rate will be higher, and alternatives such as the FHA program which don't raise your interest rate for a lower credit score can have additional cost requirements for mortgage insurance, and that can be a deterrent to using this route to get a lower rate. As well, if you have a small equity stake or high total debts, your interest rate may be higher and combinations of these elements can lift your interest rate to levels well above the best-of-the-best offers you see advertised in the market. In these situations, you're not well aligned with today's underwriting standards, and this may affect your ability to hit your refinance goal.

If you can't document your income or assets fully, are self-employed, or have sporadic sources of income, you may end up outside the conventional, conforming marketplace in what's called the "non-Qualified Mortgage" (non-QM) market, where interest rates are often higher as a matter of course and where it can be also harder to find the credit or loan terms you want. This may cause you to be misaligned, too.

Misalignment can also occur even if your credentials are stellar. You may be a great borrower but need a jumbo mortgage, but the market for these non-QM loans has been challenging for borrowers at times with unusually elevated rates, limited availability of loan choices or other restrictions. Yet another example of misalignment might be if your goal is to take money out of your property via a cash-out refinance, but you aren't allowed to pull as much equity out of your home as you need due to today's stricter Loan-To-Value ratio requirements. These are the kinds of misalignments that may not make it the right time for you to refinance, regardless of how attractive interest rates might be.

If your financials, credit, paperwork, equity and other important components of the deal are not well aligned with today's requirements, the higher rates and fewer choices available to meet your needs may or may not make it a good time for a refinance. You need to see how you fit in... and if you do, if what's available to you can still help you attain your goal. If not, you may need to wait until conditions are more suited to your needs.

How will I know when it's time to refinance?

The process for evaluating other common or even uncommon refinance goals all follows the same path:

• Define your goal
• Get a sense of your time frame
• Figure our how you'll pay for your refinance
• Review your alignment with the market, then check rates and costs
• Run calculations against your time frame
• See if your goals can be met, and if so, shop for deals

Is the last entry on the list "they can" or pretty close? Now it's time to refinance -- no matter if the interest rate break is 0.5% or 2% (more almost always better, of course).

If it's time to refinance: Taking action

Your first call should be to the lender who holds your loan. They may or may not be able to offer you a simpler refinance -- and may or may not even be able to help you with the loan you'll need to hit your goal. Even if they can, however, this should not be your last or only call; lenders participate in the market today in disparate ways, and you need to shop around to see what deals are available to you before you place an application. Don't assume that the first price quote you get is the best one or necessarily even a competitive one -- you need to see what a number of lenders have to offer for your situation, then choose the best fit for your needs.

What if it's not time to refinance? Are there alternatives?

If it's not time to refinance, there may still be ways to hit your goals. For example, although there would be no cash-flow improvement, you might be able to prepay your mortgage to achieve savings very similar to refinancing, or take a home equity line of credit to free up cash. You may be able cancel PMI simply by waiting a little longer for home prices to rise and your mortgage balance to decline, then asking your lender to cancel it. If you want a shorter loan term to pay off your mortgage before retirement, for example, you can always prepay your mortgage to any term you like with HSH's It's My Term^sm calculator.

Learn more about refinancing by reading HSH's wealth of refinancing articles, calculators and tools.