I know what you’re thinking: “I’m at home, I haven’t been out to eat in months, there’s no sporting event or concert on the horizon, but what I really want to do is put on my mask, meet at a title company and sign a stack of papers thicker than Moby Dick—I want to refinance my mortgage!”
Ok, maybe that wasn’t your thought, but with rates as low as they have been in current weeks, should it be?
Because of the wide range of fees, and hassle involved with a re-finance, analyzing when a refinance would make sense can seem overwhelming, but answering these four questions to start really helps:
- What is the long-term objective for your house?
- What will you gain by refinancing?
- What does it cost to refinance?
- When is the breakeven?
Once you know the answer to these questions, it’s much easier to determine if you should take the next step in doing deeper analysis to determine if the fees (and all the paperwork!) are worth it.
As of this writing, mortgage rates have been hovering right around 3% (and some days even lower). The reason is a combination of several factors but the most prominent are that the Federal Reserve has lowered the Federal Funds Rate (essentially the overnight-rate banks pay when they borrow from other banks), and that consumer demand for mortgages (both for purchases and refinancing) has fluctuated. Ultimately, your financial situation and the property you own are going to affect the rate you can get, but Freddie Mac and Mortgage News Daily are pretty good sites to review up-to-date mortgage statistics.
If the potential rate is materially lower than what you are paying on your current mortgage, considering a refinance is worthwhile. I find that if the rate is over .5% less than what you’re currently paying, then it’s likely worth exploring.
So, let’s fast forward, you get a rate quote and the rate is attractive. Below are the four questions I reviewed above and implore you to consider:
1. What is the long-term objective for your house?
At Cordant, we are always pushing clients to start with the end goal in mind and the reason is simple: details of a financial decision can be overwhelming especially when you don’t keep the objective top of mind. When you consider a mortgage, there are a wide range of fees involved and it becomes increasingly important that you focus on what matters and not allow a minor expense to overshadow a major goal.
Yes, Title Search and Insurance Fees are incredibly annoying, but those fees alone shouldn’t keep you from making a smart financial decision. In this case, what matters most, is whether you will be better off refinancing when the long-term objective for your house is achieved. If, for example, the objective is to move in two years, the fees (and maybe the pain of signing that stack of papers) may not be worth it. If on the other hand, your objective is to remain in your home for the rest of your life, the benefits of the refinance may completely eclipse the fees and aggravation over time.
Bottom line: start with the objective so that you can determine if the refinance will make you better off. Then ask the second question:
2. What will you gain by refinancing?
There are two main benefits to refinancing a mortgage: The first is to reduce your monthly mortgage payment, the second is to save on the overall interest you will pay on your house in the long run. It’s important to understand how this works and I think these two examples highlight this well:
- Example 1: Homeowner has 23 years left on a 30-year, fixed-rate mortgage and then refinances again for 30-years at a lower rate.
In this example, the monthly payment will drop but the homeowner could end up paying more interest in the long run because now they’ll pay off the home over a total of 37 years.
- Example 2: Homeowner has 23 years left on their loan and then refinance with a 15-year mortgage.
In Example 2, the monthly payment may actually go up, but they may pay tens of thousands less in interest over the long run (and have their house paid off 10 years sooner).
Whether either example will be beneficial for the homeowner will depend on the ultimate objective for their home. The key is to understand what exactly the benefit will be so that you can determine whether the costs of the refinance are worth it.
3. What does it cost to refinance?
As you might imagine, your potential benefits from refinancing depend on how much it costs to implement the change. Closing costs are generally between .75% and 1% of the loan and while the actuals will be specific to your situation this is a good starting point in evaluating the potential benefit prior to reaching out to a lender.
4. When is the breakeven?
Simply put, when does the benefit outweigh the costs? If you’re considering refinancing, a good starting point is the payback period for your closing costs.
Consider a homeowner who purchased a home in January of 2018 with a $500,000 loan and a 4.25% interest rate. The owner is now considering refinancing at 3.25%. The homeowner will have a smaller monthly payment after refinancing. Here is a breakdown of the details in this example:
|Loan Origination Date||1/1/2000||6/1/2020|
|Original Loan Amount||$500,000|
|Loan Type||30 Year Fixed||30 Year Fixed|
|Principal and Interest||$2,460||$2,176|
|Monthly Savings from Refinancing||–||$284|
|Estimated Closing Costs||–||$5,000|
In the example above, assuming closing costs are 1% of the loan, the breakeven is in less than 6 months. The homeowner would cover the closing costs with savings in 18 months. In other situations, it can take years to break even on the closing costs, so you’ll need to consider how long you plan to own in evaluating this benefit.
For the homeowner in this example, a refinance could make financial sense. However, as I said in the beginning of this post, these 4 questions are a great place to start. If the refinance is still attractive after answering these questions, the next step is to do a deeper dive into the cumulative benefits of a refinance. The benefits should also be analyzed in light of three additional factors:
- The total interest paid on your loan over time;
- What you plan to do with monthly savings from a refinance; and
- Taxes (and tax law changes)
In my next post, we will focus on analyzing the cumulative benefits in light of these three factors.