When should you refinance your home loan?

When you refinance your mortgage, you’re basically trading in your old loan for a new one with a new interest rate and length of term. As noted, you should only consider refinancing when interest rates are lower than you’re now paying. That’s because the interest rate on a home mortgage is connected to the monthly payment.

The lower the interest rate on a home mortgage, the more of your monthly payment goes toward paying down the principal. This means that you can build equity in your home faster than you would at a higher interest rate.

But what about the term? If you refinance at a lower interest rate with a longer-term mortgage, you will reduce your monthly payment. And that may be your chief objective for refinancing. Keep in mind, though, that a longer-term mortgage (even at a lower interest rate) may increase your total interest costs over the years.

What about refinancing with a shorter-term mortgage? This may decrease your total interest costs because you’ll pay off the loan faster. Yet, a shorter-term mortgage will likely increase your monthly payment. Again, you need to consider your chief objective for refinancing. If your main goal is to pay off the loan as soon as possible, and you have the extra money to put toward a house payment, a shorter-term mortgage may be for you.

Lowering your monthly payment or paying off your loan faster are two reasons for refinancing. There are two other reasons to consider refinancing when prevailing interest rates go down. They are:

• Switching to an adjustable rate mortgage (ARM) with better terms, or
• Switching from an ARM to a fixed-rate mortgage.

ARMs pose challenges, though. That's because monthly payments change when interest rates change, and if interest rates go up, you may not be able to afford the payment.

To prevent a dramatic increase in your payment, you may want to refinance under an ARM with better terms. In this case, be sure to ask the lender about three things:

• The initial rate of interest.
• The fully indexed rate.
• Rate adjustments you may face over the term of the loan.

Another way to prevent a big payment hike is to switch to a fixed-rate mortgage with a steady interest rate and monthly payment. Many people like the peace of mind and budgeting predictability that a fixed-rate mortgage offers.

In general, refinancing is not a good idea if doing so won’t save you money. According to the Federal Reserve Board, there are three reasons why you might not benefit from refinancing:

1. If you have held your mortgage a long time. The longer you have paid down your mortgage, the more of your monthly payment applies to principal and helps build equity. But, if you refinance late in your mortgage term, you’ll “reset the clock.” This will restart the amortization process so more of your payment will be paying interest (and not building equity) again.
2. If your current mortgage has a prepayment penalty. A prepayment penalty is a fee that lenders might charge if you pay off your mortgage loan early, including for refinancing. If you’re seeking refinancing with the same lender, ask whether the prepayment penalty can be waived with a new loan. If you must pay the penalty, you will increase the time it takes to break even on refinancing. This will be true even after accounting for expected monthly savings.
3. If you plan to move from your home in the next few years. If you’re planning to move soon, the savings you’ll see from lower monthly payments may not exceed the costs of refinancing. Use a break-even calculation to determine whether it is worthwhile to refinance.

There are other things to consider before refinancing. They include:

• Your eligibility to refinance under lender criteria.
• Your credit standing.
• Costs associated with refinancing, which might range from three to six percent of the outstanding principal.

A good place to start looking for information and asking questions is with your current lender. But don’t stop there! Check out other sources, too, including the websites listed under Related resources below.

Remember — refinancing is an important decision that will affect your financial future. So it's in your best interest to gather as much information as you can about the process.