Before we get into when and why you should refinance, I want to quickly define what exactly it means to refinance. In a nut shell, refinancing is when you pay off your current mortgage with a new one.
So what’s the point of that? The whole point of refinancing a mortgage is to take advantage of a better interest rate.
So let’s say you’ve improved your credit score since your first mortgage, and you suspect you could probably qualify for a better interest rate now. With this example, you can pay off your old mortgage with a new one, and enjoy a lower interest rate for the remainder of the loan, which, of course, means you will pay a smaller mortgage each month.
Now doesn’t refinancing seem like a great thing?
When to Refinance
Okay, so now we can talk about scenarios when it makes sense to do so. Just because your neighbor, best friend, or closest cousin refinanced doesn’t mean you should. But as a general rule of thumb, it’s a good time to refinance if the interest rate is two percentage points below your current rate. You just want to make sure the money you would save each month will make up for the costs associated with refinancing your mortgage (origination fees, etc.).
You may also want to refinance if your income has increased, because now you can afford a higher mortgage payment and shorten shorten the term of your mortgage. However, this only makes sense if the current interest rate is lower for the shorter-term mortgage. Oppositely, you could even just refinance to make larger principal payments against your mortgage to pay it off sooner.
A third (and common) reason for refinancing occurs when home buyers trade their adjustable-rate mortgage (ARM) for a fixed-rate mortgage. At this time, you may have noticed that home foreclosures have gone way up, which is largely due to ARMs that are adjusting and catching the homeowners off guard with much higher interest rates. In my experience, many of these people now wish to refinanced into a fixed-rate mortgage. No more surprises!