Considering Refinancing? Read This First

30-year mortgage rates continue to be at an all-time low.  As rates continue to drop, increasing numbers of homeowners are considering refinancing their existing mortgages. Banks across the country reported home refinance applications have reached their highest level in three years.

If you own a home with a mortgage rate higher than 4 percent, you may be able to save money by refinancing. But a mortgage refinance isn't necessarily the right step for every homeowner. Before you apply, take some time to think carefully about your specific situation and talk with your lender. Answering these four questions can help you make a more informed decision about whether to refinance your home.

1. What is your goal for refinancing?

Most people refinance to save money: You want to get a lower interest rate, lower your monthly payment, or lock in a fixed interest rate (rather than adjustable). But refinancing doesn't always guarantee that you'll meet your financial goal.

 A lower interest rate: You can save significant money by locking in a lower interest rate. A $100,000 mortgage with a 6 percent rate would cost almost $44,000 more over 30 years than the same mortgage with a 4 percent rate.

However, consider the total number of years you'll be in mortgage debt—usually, the longer you're in debt, the more interest you'll pay. So, if you've already held your mortgage for 10 years and you refinance with a new 30-year mortgage, you'll be in debt for a total of 40 years. Take some time to figure out the total amount of interest you'll pay over the 40 years versus the amount you'll pay by completing your original 30-year mortgage. If it's cheaper to stick with your higher rate over a shorter time period, that may be the best bet. (If you can afford the payments on a 15-year mortgage with a lower rate, however, you're likely to save money over time.)

 A lower monthly payment: Refinancing may allow you to lower your monthly payment.  But again, keep in mind that you'll likely be paying more interest over the life of the loan. The best way to save money on your mortgage is to pay off the loan as soon as possible. But if a lower payment regardless of the long-term is your desired outcome, refinancing could be a good option for you.

 A fixed interest rate: If you currently have an adjustable rate mortgage, refinancing to a fixed rate may be a good option. You can lock in low rate and not worry about fluctuating interest rates over the next few years.  Plus, try to keep the term of your loan as short as possible, so you aren’t simply stretching your debt over time.

2. How much will a home refinance cost you?

Refinancing is basically getting a new mortgage with new terms on the same house—and just like when you got your current mortgage, you'll have to pay closing costs, or fees to the lender, when you refinance. If the goal is to save money, it's important to know how much closing will cost you.

In most cases, closing costs run about 2 percent to 5 percent of the total value of the loan. Some lenders will allow you to finance the closing costs, which will reduce your upfront costs but will add to the amount of interest you'll pay over the life of the loan. For instance, adding an extra $6,000 to a $200,000 mortgage adds another $4,312.17 in interest over 30 years.

Talk to your lender to see if they can offer discounts on any of the closing costs. Some fees are mandatory, such as appraisal fee, title fee, and recording fee. But others, such as origination, application, and underwriting fees, may be charged by the lender and could possibly be reduced.

3. How long do you plan to stay in the home?

Refinancing your mortgage may save you money over time, but it could cost you money now. One key consideration should be how long you plan to keep living in your home.  If you plan to keep your home for at least five years or more, it’s probably worth the cost of refinancing.  But if you’re thinking of moving within the next two years, it may not be worth it.  A mortgage professional can help you calculate your breakeven point.

4. Can you qualify to refinance?

You have to qualify for a refinanced mortgage just like you do for an original mortgage. That means your lender will look at a number of factors including your credit score, debt-to-income ratio, and the loan to value (LTV) ratio. To be eligible for the best refinancing rates, you will want to make sure your credit and credit score are in good shape. You can check your credit for free each year at annualcreditreport.com. Your debt to income ratio (all your monthly debt payments divided by your gross monthly income) should be approximately 43% or lower to qualify for the most attractive rates.

If you've been paying on your current mortgage for a while, you've likely built up some equity in the home. That will help improve your LTV ratio, which represents the portion you're borrowing versus the total value of the home. If your home's value has increased since you purchased, that that will also lower your LTV ratio. Lenders generally look for an LTV ratio of 80 percent or lower.

The bottom line:

Refinancing can be a smart financing move if it reduces your mortgage payment and shortens the term of your loan. But a lower rate doesn’t always mean it’s a good deal especially if you don’t plan to stay in your home long.  The good news is that a mortgage professional can help you determine the best choice for your situation.