Interest rates are once again near all time lows and it may be worth considering a refinance of your home mortgage. Before you call your mortgage broker or bank however, there are some important things to consider. Here is how to know if a refinance is right for your situation.
The most popular reason to refinance is to get a lower rate, and getting a lower rate is a good idea most of the time. After all, if your interest rate is 4% currently and you could refinance that same mortgage at 3.5% then your monthly interest costs go down. Shouldn’t you always take the lower rate? Surprisingly, the answer is no. There are several instances where refinancing would not make sense even if the interest rate is lower. Here are a couple of potential traps to consider.
First, refinancing does cost money. There are always fees for appraisal, title insurance, recording, etc. that will run $3,000 to $5,000. Sometimes there are ‘points’ or ‘loan origination fees’ that will increase the cost of the loan still further. Before you take the lower rate make sure you understand these costs even if they will be added to the principal balance. Remember that costs added to the principal of the loan are costs that offset your monthly savings from the lower rate.
So how do I know if the up-front costs are worth the savings? I like to use a simple calculation to estimate the break-even point, the length of time that it will take to recoup the up-front costs. I take the up-front costs and divide by the annual savings. Calculating the annual savings can be complex but you can come very close by taking the principal balance and multiplying by the change in rate. For example, if my loan balance is $300,000 and I will be lowering my rate by .5% then I multiply $300,000 by 0.5% to estimate my annual savings. In my example I’ll save $1,500 per year. If my loan costs my $5,000 in fees, then it will take me about 3 years to recoup the cost of my refinance. If I pay points and my loan costs me $10,000 then it will take me about 6 years to recoup the cost of my loan. If there is a chance that you will be moving before the breakeven point, then a refinance may not make sense even if the rate is lower. Americans on average move every 7 years, so sometimes it is better just to keep the existing loan.
Secondly, refinancing ‘resets’ the loan term, which could result in paying higher total interest even though the rate is lower. This statement may not be intuitive so allow me to provide an example. Let’s assume you currently have a $300,000 mortgage balance at 4% and 20 years remaining on the life of the loan. In our example you will pay approximately $136,000 in interest over the remaining life of the loan. If you choose to refinance to a new 30-year loan at 3.5% then you have reset the loan term to 30 years and you will pay approximately $184,000 over the life of the new loan. Note that the total interest paid is higher because the time is longer. Thankfully, this problem has an easy solution. You could simply refinance into a new 20-year loan. A $300,000 20-year loan at 3.5% would have total interest of about $117,000 and a lower monthly rate.
Lastly, I recommend that you make your refinance decision in the context of your overall financial plan. For example, consider how the new mortgage will impact your retirement savings rate. Or if you are already retired, how will the new mortgage impact your draws from your retirement accounts. If you are considering a refinance please feel free to give us a call to help you consider what is best in your situation.