Should You Refinance Your Mortgage?

Dear Carrie,

With interest rates dropping, I'm thinking of refinancing my mortgage. What do I need to know?

—A Reader

Dear Reader,

Interest rates are on a lot of people's minds these days. For savers, rising interest rates are a plus, but borrowers benefit more when interest rates are low. For homebuyers and existing homeowners with a mortgage, lower interest rates can mean saving thousands in interest charges. But whether it makes sense to refinance your own mortgage depends on several factors.

What kind of mortgage do you have?

There are two basic types of mortgages: fixed and variable.

• A fixed-rate mortgage locks in both your interest rate and monthly payments for the life of your loan.
• An adjustable-rate mortgage (ARM) is a hybrid, with a fixed interest rate for a specified initial term—say, five years—after which the interest rate may reset or fluctuate, typically depending on prevailing interest rates.

Changes in interest rates affect fixed and adjustable mortgages differently. While adjustable rate mortgages may be affected by short-term rate changes, fixed mortgage rates tend to be more closely aligned with the 10-year Treasury note.

Therefore, if you have an ARM, a decrease in the short-term federal funds rate may lower your rate. If you have a fixed-rate mortgage, you should instead pay attention to long-term bonds like the 10-year Treasury note.

Although these rates are related, they aren’t the same and can act differently from one another. Sometimes they both may decrease, or both may increase. Or one may go up, while the other goes down.

Bottom line, pay attention. When rates decline, you may have an opportunity to refinance either your fixed or adjustable mortgage at a lower rate.

But rates aside, deciding whether or not to refinance depends on a lot of personal factors. So you first need to ask yourself some questions and look at some specifics.

What's your goal?

People refinance for a lot of reasons. Do you want to lower your monthly payment? Reduce the length of your mortgage? Take out extra money for home improvements? These are important initial questions.

If decreasing your payment is a top priority and you can lower your interest rate by .5 to 1 percent, it's probably worth the effort. For instance, lowering the interest rate on a $350,000 30-year fixed mortgage by 1 percent could lower your monthly payment by about $300 a month.

On the flip side, if your goal is to shorten the length of your mortgage and you refinance that amount for 15 years, your monthly payment would go up, but you'd save a considerable amount in interest over the life of the loan.

How long will you be in the house?

Refinancing usually involves paying points and fees. Points basically represent interest you pay upfront to get a lower rate on your loan. It's not uncommon for points and fees to add up to 3-6 percent of your loan. You can pay this out of pocket or, often times, add them to the balance of your loan.

However you pay them, it will take time to get to the breakeven point where these additional costs are offset by the lower rates, so you have to think realistically about how long you intend to be in your home. If you plan to sell in the near future, the extra cost of refinancing may outweigh the monthly short-term savings.

How much home equity do you have?

Just like with the down payment on a first mortgage, if you have less than 20 percent equity in your home, you'll likely have to pay private mortgage insurance (PMI). PMI fees can range from less than half a percent up to about 1.5 percent of your loan. While that may not add a considerable amount to your payment, if your goal is to reduce your monthlies and you have very little equity, you may want to reconsider.

Do the math

As you can see, it becomes a numbers game. A good way to start is to run some different scenarios using an online mortgage refinance calculator. That way you can see how it all adds up and decide on the best combination of rate, monthly payments, costs and loan term for you.

Be aware that to get the best rate, you need to have a good credit score, so you might want to get a head start by looking at your credit report at annualcreditreport.com. The higher your credit rating, the lower the interest rates you will qualify for. Also, take steps to pay down outstanding debt like credit card balances and be prepared to meet any unexpected closing costs. Take care to avoid opening any credit lines during the refinancing process.

And if you're increasing your loan balance or shortening the loan term, each of which could increase your monthly payment, make sure you're being realistic about your ability to handle the new payment from your income. The last thing you want to do is to shortchange your retirement savings or emergency fund for the sake of your mortgage.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.