When mortgage interest rates drop more than a percentage or so, some homeowners will decide to refinance their loans to get a better rate. Consider that average interest rates on fixed-rate mortgages have ranged from less than 7 percent in the late 1990s to more than 15 percent in the early 1980s, and you can see that refinancing can result in significant savings for the homeowner.
A general rule of thumb is to refinance when interest rates drop 2 percentage points or more. For example, if you have a $100,000, 30-year, fixed-rate mortgage at 10 percent, you will pay more than $215,000 in interest over the next 30 years. But if you have a $100,000, 30-year, fixed-rate mortgage at 8 percent, you will pay less than $165,000 in interest over the same period.
The two percent rule makes sense in many cases; however, sometimes it makes sense to refinance even when interest rates drop only 1.5 percent or even 1 percent. Homeowners who plan to keep their homes for many years may still profit from refinancing when interest rates drop less than 2 percent, since they will have many years to recoup the costs associated with establishing a new mortgage loan. Another general rule is to refinance when your interest savings will cover all loan costs in two years or less.
Many homeowners refinance to reduce their monthly mortgage payments. If you have built up equity in your home, you also may want to consider replacing your old mortgage with a larger loan, pulling out some of the equity you've built up as cash for debt consolidation or other purposes.
Or, you may want to use the savings in interest to reduce the length of your mortgage. For example, a $100,000, 15-year, fixed-rate mortgage at 8 percent will cost you less than $75,000 in interest over the next 15 years—compared to $165,000 for a 30-year mortgage. Another way to reduce the mortgage term is to make extra payments whenever possible. You also sometimes can establish a twice-monthly payment plan with the mortgage lender to shorten the mortgage term.
If you have an adjustable rate mortgage (ARM) and interest rates seem to be rising, you might consider replacing your ARM with a fixed-rate mortgage. Some people prefer the security of knowing precisely what their mortgage interest will be, rather than worrying about whether—or how much—it may go up in the future.
There are many reasons to refinance a mortgage. You should evaluate the financial impact of refinancing as part of a sound financial planning strategy.
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