Most people refinance a home to save money, at least in the long run. If you're contemplating making that move, it's a good idea to verify first that it's the most financially efficient way to achieve your goals and to ensure you're well prepared. But there are things to consider first.
Improve your credit score
Check your credit score first. The better it is, the cheaper the loan will probably be. A score between 740 and 850 should help secure a good rate. If you're a couple hundred points off, it might be a good idea to take a few months to build credit before applying to refinance.
Crunch the numbers
To calculate the savings from a refinance, subtract the proposed monthly principal and interest payment from the current one; divide the closing costs by that number. That gives you the number of months it will take for the transaction to start saving you money. Closing costs often amount to 3% to 6% of the loan value.
For example, if a new mortgage saves you $120 each month and the closing costs are $3,600, it would take 30 months to pay off the costs of the refinance. If you intend to stay put for at least another seven years, or 84 months, net savings would total $6,480. The longer you plan to stay in a home, the more savings you'll accrue after recouping costs.
Keep in mind that if you've had a 30-year mortgage for a decade or more, you may have already paid most of the interest due. Refinancing resets the amortization process, meaning for the first 13 years or so, most of what you'll pay will go to interest, not the balance owed.
Show off savings
If you're refinancing with a different lender from where you save, consider consolidating your business. If you keep a year's worth of mortgage payments in a savings account, in addition to an emergency fund, the financial institution may be more likely to cut a deal.
Lock it in
Weigh the options between an adjustable-rate mortgage, or ARM, and one with a fixed rate. The latter ensures monthly loan payments will remain stable, whereas those for an ARM may change periodically. If you find a great loan rate, but aren't ready to commit, ask about a rate lock, in which the lender agrees to hold that rate for you for a specific period of time.
Some lenders offer the option of using points to reduce the interest rate on a mortgage. The typical cost comes to 1% of the loan amount to cut the rate by 0.25 percentage point. This can save money down the line if you intend to stay in a home for a long time. On a $200,000 mortgage, two points would typically cost $4,000 up front to trim the rate by 0.50%. That could mean cutting more than $21,000 in interest costs on a 30-year fixed loan at 4% instead of 4.5%.
Even after finding the best rate, closing costs can be expensive. Depending on how long you plan to stay in a home, that expense can outweigh the potential benefits of a better rate.
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