Interest rates have come down across the board the last few weeks to levels not seen since 2016. This has led us to begin to have conversations with many of our clients about the considerations that go into whether or not refinancing their mortgage(s) makes sense. In this commentary, we share our thoughts on a selection of high-level factors that anyone thinking about refinancing ought to bear in mind.
When does it make sense to refinance?
In general, if you can save money on your existing mortgage by refinancing, it could make sense to explore. But how do you know if you are saving money? It’s not all about your monthly payment or length of the loan. Here are some situations when that might be the case.
You can get a lower rate than the one you’re currently paying.
Mortgage rates fluctuate all the time, as they’re impacted by a variety of factors, including U.S. Federal Reserve monetary policy, market movements, inflation, the economy and global factors. If mortgage rates fall, you may be able to save by securing a lower interest rate than you have on your existing loan. This is known as rate-and-term financing — when you refinance your mortgage for one with a lower interest rate, and one that usually has the same remaining term.
So how much should mortgage rates fall before you consider refinancing? The traditional rule of thumb says refinance if your rate is one to two percent below your current rate. But in reality, everyone’s financial goals and needs are different. A one percent interest rate reduction may net significant savings on a $1 million mortgage but will be less beneficial for a $100,000 mortgage.
You have an adjustable rate mortgage and you have the opportunity to convert it to a low-rate fixed rate mortgage.
Another time refinancing may be helpful is if you have an adjustable-rate mortgage (ARM) and current mortgage rates are the equal or lower than the ARM rate you have. With an ARM, the interest rate changes over time, usually in relation to an index, and so your payments can go up or down. Converting to a fixed mortgage rate gives you the stability of a fixed-rate loan and fixed payment, which is one of the biggest fears for those with an ARM.
Your home has increased in value and you have a need for cash.
When you get a cash-out refi, you take out a new mortgage that’s larger than what you previously owed, and you receive the difference in cash. A cash-out refinance is an alternative to a home equity loan. Of course, with cash-out refinancing, it’s important to make sure you’re using the money responsibly and not getting into unsustainable debt — remember that it’s part of a loan, so you’ll have to pay it back along with the rest of your mortgage.
Things to consider and calculate before refinancing
Regardless of which specific scenario someone considering refinancing falls into, it’s critical that they consider the costs both tangible and intangible of refinancing as refinancing a mortgage can be moth expensive and time consuming. In terms of tangible expenses, here are some of the typical fees associated with refinancing:
- Mortgage origination fee: generally, about one percent of the loan value
- Mortgage application fee: usually, $250-$500
- Appraisal fee: typically, $300-$600
Once you understand the costs of rebalancing, it’s important to consider the term of your new loan. Before you decide to refinance, calculate your break-even point and how the overall costs — including total interest — of your current mortgage and your new loan would compare. Your break-even point is the point in time where the costs associated with refinancing the loan are equal to the savings. The break-even point tells you how long it may take for the refinance to pay for itself. To calculate the break-even point, divide your mortgage closing costs (those listed above plus any others) by the monthly savings your new mortgage will get you. If you’re paying $10,000 in closing costs but you’ll save $300 per month as a result of refinancing, it will take you 33 months to break even. If you don’t plan on staying in your home past the break-even point, it probably doesn’t make sense to refinance.
Take note that refinancing usually makes more sense earlier into your mortgage term. In the early years of your mortgage term, your payments are primarily going toward paying off interest. In the later years, you begin to pay off more principal than interest, meaning you start to build up equity — the amount of your home that you actually own. Once you refinance, it’s like you’re starting over. Say you’ve been paying off your old mortgage for 10 years, and you have 20 years left to go. If you refinance then into a new 30-year mortgage, you’re now starting at 30 years again.
Lastly, it’s important that you figure out whether you’re willing to invest the effort. Refinancing, just like applying for a mortgage, can take significant time and effort. You may need to obtain additional paperwork and spend time understanding your options, so consider whether the savings you could receive make up for this extra effort.
We hope this helps you understand all that goes into the decision to refinance or not. Please do not hesitate to reach out to us if you want to talk about your financial situation, as this is just one of the hundreds of questions and situations we analyze for clients regarding their financial life.