Refinancing your mortgage is a common homeowner strategy for lowering monthly payments or otherwise finding some financial flexibility.
But when is the best time to refinance?
It's a question that buzzes around the heads of many homeowners. Yet it can be difficult to answer, as no two financial situations are alike. In reality, there are a multitude of factors that impact the decision to refinance, including your credit score, long-term housing plan, level of equity in your home and current financial needs.
To help you nail down a good time to refinance, let's explore some life milestones and financial events that make refinancing advantageous, and what benefits you might enjoy.
What is a refinance?
First, let's define what a refinance is, exactly.
Refinancing your mortgage means taking out a new mortgage to pay for the old one. Typically, this exchange nets homeowner benefits like more favorable terms or a lower interest rate. Some common reasons for refinancing include:
- Reduced interest payments.
- Shorter mortgage term.
- Access to cash through equity in your home.
- Converting to a different mortgage structure.
Multiple refinancing options exist to help homeowners accomplish various personal finance goals, like paying off their mortgage faster or cashing out for immediate access to funds that can be used for a renovation. For example, a homeowner may choose to refinance right before an adjustable-rate mortgage (ARM) resets so they can lock down a fixed-rate mortgage. Homeowners on a 30-year interest-only plan, meanwhile, may switch to a fixed-rate mortgage if they don't feel financially secure enough to sustain the higher monthly rates that follow the initial 10-year interest-only period.
Regardless of your reasons for refinancing, you have to be sure the move makes financial sense for you. Many would-be refinancers forget that refinancing entails paying closing costs on the new loan, like lender fees, titling and escrow charges. How can you ensure that refinancing is right for you? By calculating your break-even point.
Start by totaling together your closing costs for the new loan. For this example, the involved costs amount to $2,550. Then, figure out your monthly savings under the new mortgage, which will be $105 a month. Divide your costs by monthly savings (2,550/105) and the break-even point for this example is roughly 24. That means it would take around 24 months for you to recoup the costs of refinancing. If you plan to stay in your home for less than two years, a refinance likely wouldn't make sense. But if you stay in your home longer, you're in line to enjoy pure cost savings for the rest of the mortgage after those two years.
Now, without further ado, let's answer the question of "When is the best time to refinance?"
1. Mortgage interest rates are falling
Each homeowner's situation is unique, but a grade-A time to refinance in general is when mortgage interest rates are on the decline.
The interest rate you are quoted on your mortgage is influenced by several factors, including the federal funds rate controlled by the Federal Reserve. The U.S. central bank raises and lowers this benchmark interest rate as a monetary policy tool, often decreasing the rate when the economy is struggling. Lower rates mean it's cheaper to borrow money, which in theory stimulates economic activity.
So, when rates are trending downward, it might be a good time to refinance. Proof of this is the fact that mortgage interest rates reached historic lows during 2020 when the American economy was hammered by the coronavirus pandemic. For example, homeowners with a fixed-rate mortgage may want to refinance at such times, as they can take advantage of lower rates and decrease their interest payments.
If you're considering a refinance, make sure to keep an eye on interest rate trends, as they won't stay low forever. Timing is essential, and you don't want to miss out on your window of opportunity for monthly savings or other benefits.
2. You got married
Recently married couples may opt to refinance a mortgage for several reasons:
- Adding a news spouse to the title of the house.
- Merging finances together.
- Tapping into funds via a cash-out refinance to cover wedding or honeymoon expenses.
In some cases, marriage improves a couple's debt-to-income ratio, since both spouses' incomes can be factored into the equation. A lower debt-to-income ratio may be an opportunity to qualify for a better mortgage. If both spouses have a solid credit score, they may also qualify for lower interest rates.
Conversely, it may make sense to refinance after a divorce. This option may be pursued to remove an ex-spouse from the title and mortgage, but should only be sought once the divorce is entirely finalized.
3. Home values are increasing
Each monthly payment you make on your mortgage earns you equity in your home. Your level of equity can be determined by subtracting your outstanding mortgage value from the value of your home.
This means that if housing prices are trending up in your area, you may have more equity in your home than you think. This could make refinancing a good decision.
A cash-out refinance could be advantageous for homeowners in such situations. This type of refinance can give your household a much-needed influx of funds to be used for whatever purpose you deem appropriate.
One idea here is to dedicate that cash to a renovation or another home project. Improvements to your home are likely to raise the eventual selling price, and if home prices are already trending up, you can further pad that value and recoup your investment if you don't plan to stay in your home long.
However, be careful with the home project you choose. Not all are guaranteed to provide a high rate of return. For example, a garage door replacement or kitchen remodel can recoup a lot of your initial cost, but a master suite addition isn't as cost-effective. You may need to trade style and comfort for functionality when making this decision, and this guide from Remodeling™ magazine can help you choose the best project in terms of job cost versus impact on resale value.
Alternatively, proceeds from a cash-out refinance can be used to pay down credit cards, other personal high-interest debt or to fund an emergency savings account or college education.
4. You came into an inheritance or other windfall
It's not unusual for homeowners to refinance their mortgage after a notable increase in income, a life insurance payout, a large inheritance or other windfalls. Access to new funds is incentive to move from, for example, 30-year fixed rates to 15-year fixed rates.
First, the rates tend to be lower since the life of the loan is shorter, which means you pay less interest in the long run. Second, some states let lenders dole out a prepayment penalty if the homeowner exceeds the maximum allowable payment for a given time period. These penalties may also apply to refinancing. The legality of prepayment penalties varies by location. In Michigan, for example, prepayment penalties can only be applied during the first 24 months of a loan, after which their use becomes restricted, according to The Nest™.
Homeowners who live in states that restrict or limit prepayment penalties, or homeowners who can absorb the prepayment penalty and still come out ahead in the form of lower interest payments, may choose to refinance to a shorter mortgage term following an uptick in income.
5. Your credit score has changed
Your credit score is one of the primary factors in determining your mortgage interest rate. Yet, your credit score likely changes over time. If it's increased since the time you took out your initial mortgage, a refinance may make you eligible for even better interest rates.
What goes into a credit score?
- Payment history: Your track record of making timely payments.
- Credit utilization: How much of your available credit you use (hint, one-third of your credit limit for any one credit account is optimal).
- Length of credit history: Or the age of your current debts.
- Credit mix: Your mix of installment and revolving credit accounts.
- New accounts: The share of recently opened credit accounts.
If your credit score has increased (either because of improvements in these five factors or because you addressed a credit report error that was keeping your score down), it may be a good time to refinance.
6. Your adult children are moving out
Empty nesters could be incentivized to refinance their mortgage for a variety of reasons, like a desire to downsize. Generally, parents whose children have recently gone to college will consider one of the following options:
- Cash-out refinance: Common selection for parents whose property value has increased, and who need access to funds to help pay for their children's education.
- Lower monthly payments: Extending a fixed-rate term (e.g., from 15 years to 30 years) may increase overall interest but can lower monthly payments, which can help parents who need access to funds for education.
- Shortened repayment term: This option may appeal to parents whose children are on a scholarship or who go right into the workforce. With fewer expenses, this acts as a chance to expedite repayment with a higher monthly rate, but note that prepayment penalties may apply in certain states.
7. You're approaching retirement
Homeowners who are ready to put their feet up and bask in the golden years will often refinance with one of a few end goals in mind. If they have enough money saved and perhaps a pension as supplemental income, they may choose to pay off what's remaining of their mortgage more quickly. Alternatively, they can extend the term of their mortgage slightly and make lower monthly payments due to the fact that they are no longer working.
Tapping into equity via cash-out refinancing is also an option but is generally used as a last resort in the event that an unexpected expense arises. Retirees or homeowners who are close to retirement don't usually refinance their mortgage if they intend to move in the near future, since this will likely cost more money in the long run in closing costs.
Comerica Bank has refinancing expertise and options to aid you
Ultimately, only you can answer the question of "When is the best time to refinance?" Your personal finances and unique life circumstances will dictate when and if a refinance makes sense.
If you do go down the refinancing path, Comerica Bank is here to guide your way with expert advice and a range of mortgage refinance options.
Contact us today to learn more about refinances, next steps and what refinancing method is best suited for your needs and wants.
