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The Basics of Refinancing Your Mortgage

You would think that mortgage applications always come from people looking to buy a house. But you would be wrong.

Currently, about two-thirds of the mortgage applications in the United States are from customers who already have homes and just want to change the terms of their mortgages. In other words, they're looking to refinance their mortgages. (Learn about mortgage modification through Obama's Making Home Affordable program; see Resources, below.)

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Big Savings

A refinance can change the basic terms of a mortgage -- for example, it can convert a 30-year fixed loan to a 15-year fixed one. Most refinances, however, are attempts by consumers to save money as interest rates fall (see Resources, below).

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For example, if you bought a house two years ago and got a 6 percent interest rate on your loan, it might be worth refinancing now to take advantage of current rates, which are closer to 5 percent. That means you're being charged less for your mortgage, which can translate to less money paid to the bank.

Frank Nothaft, vice president and chief economist of Freddie Mac, notes that the typical borrower who refinanced during the first quarter of this year got a 1.2 percentage point reduction in interest rates. (That would result in a savings of about $300 per month for someone carrying a $400,000 mortgage.)

What's more, because the housing market is in a slowdown, banks aren't issuing that many new mortgages, so they're trying to encourage refinancing. As a result, many banks will let you roll closing costs and fees into your loan balance, so you can pay them off slowly as part of your mortgage instead of paying upfront.

But if you're more than a few years away from paying off your loan, it might not make sense to refinance. That's because even though your interest rate may drop, your loan term might become 30 years again. So if you bought a home in 2006 with a 30-year mortgage, if you do nothing but make the payments, you'll have it paid off in 2036. If you refinance, the time when you become debt-free might be pushed off five years, to 2041.

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Is Refinancing for You?

If you're going to save money on your interest rate, and you don't have to pay your closing costs out of pocket, you should always refinance, right?

Not necessarily. Closing costs that are rolled into your loan are still closing costs, so you want to take a look and see how much they are. If you think you're going to move fairly soon -- say, in the next two years -- it's probably not worth incurring the fees.

The Hidden Costs of Refinancing

Paying interest for those extra years can really add up. Let's say you bought a home for $500,000 in 2006, and took out a $435,000 mortgage at 6 percent. Your average monthly payment would be $2,608, and over the life of your loan, you'd expect to pay nearly $504,000 in interest.

After holding the mortgage this long, you probably owe $400,000. If you refinanced that now at 5 percent, your monthly payments would drop to $2,147.

Wow, you might be thinking, I'm saving $461 a month!

You must, however, consider the amount of interest you're paying to extend the loan. With your new loan, you're paying $373,000 in interest, but you'd probably already paid $136,000 in interest to get to this point, resulting in a new total of $509,000. That's $5,000 more. So, even though your monthly expenses look cheaper, refinancing has actually cost you money, because you're paying more money over the life of your loan.

How to Make the Call

There are interest-rate calculators you can tinker with, depending on your particular circumstances (I'm fond of the one at HSH.com). To start, though, consider two rules of thumb:

  1. Do consider refinancing if you can drop your interest rate by at least one point (say from 6 percent to 5 percent)
  2. Don't refinance if you're already six years (or more) into your pre-existing mortgage.

Find out what you should know before buying a new condo, see Resources, below.

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Originally published on LearnVest.com; republished with permission.

Copyright © 2012 Meredith Corporation.

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