With the interest rates we've been experiencing for the last year or so, it may seem like there is no end in sight to new record-low interest rates. On July 22, Freddie Mac's Primary Mortgage Market Survey, which provides a snapshot of national average mortgage rates, reported a national average rate of 4.56% with 0.7 points on a 30-year fixed-rate mortgage. At the same time last year, the rate was 5.2% with 0.7 points. So once again, you might be asking yourself, is it time to refinance?
Assuming you can qualify to refinance your mortgage, here are some things to consider.
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Your Overall Financial Picture
Refinancing can be a great way to save money. It can also be a great way to get yourself into financial trouble. It is still possible to do a cash-out refinance, meaning that you borrow against the equity you've accumulated in your home. People use this money for things like paying off high-interest debt, financing a child's education or remodeling a kitchen. But just because you sometimes can borrow against your home equity doesn't mean you should. Many people have gotten themselves into trouble this way.
You shouldn't refinance if you suspect you will make a refinancing choice that will hurt your financial situation in the long term. Even without doing a cash-out refinance, you can hurt yourself by refinancing if you work with an unscrupulous loan officer or don't understand your paperwork and sign up for an inferior mortgage product or unfavorable terms.
Your Breakeven Period
Your breakeven period is one of the most important considerations in a refinance. To determine your breakeven period, you need to look at the monthly savings you'll create by refinancing and the total cost to refinance your loan. Let's say that by refinancing, you'll save $200 a month, and that the cost to refinance is $4,800. To determine your breakeven period, divide your refinance cost by your monthly savings. In this example, the breakeven period would be 24 months, or two years.
If you plan to stay in your house for longer than the breakeven period, refinancing might make sense. Now, if you're only planning to stay there for 26 months, will that $400 you save be worth the time and hassle of going through the refinancing process? Maybe not. But if you're planning to stay in the house for another 10 years, the refinance would save you $2,400 a year for eight years, or $19,200 (less the cost of the refinance).
This is a simplified example. The easiest and fastest way to get a complete picture of your refinancing situation is to use a detailed mortgage refinancing calculator, available online. It accounts for factors like your income tax rate - since mortgage interest is tax deductible, the difference in tax savings between your old and new mortgage is worth considering (but it's time-consuming to calculate on your own). (Learn more in Should You Refinance Your Mortgage When Interest Rates Drop?)
Other Things to Consider
One example of a more complicated refinancing situation is one where you recently purchased your house or recently refinanced and you haven't yet reached your breakeven period on that transaction. For example, say you bought your house two years ago and paid points to get a lower interest rate. Let's say you paid $3,600 in points to lower your monthly payment by $100 a month. The breakeven period for the points you paid is 36 months, or three years. If you refinance now, you'll be taking a loss of $1,200 on your previous transaction. You have to factor that loss into the savings you'll get from the new transaction. You might want to dig out your old loan papers to refresh your memory.
Of course, there is always some risk when refinancing because you may never reach or move beyond that breakeven period. Something unexpected could compel you to move before you plan to, like a great job promotion or a family emergency.
Also, some mortgages carry a pre-payment penalty. This is a fee that you are required to pay the lender if you pay your mortgage balance off early (which is what you're doing when you refinance or sell your home). If your mortgage has a prepayment penalty, the penalty amount should also be factored into your total costs when considering a refinance.
Alternatives to Refinancing
Instead of refinancing, you could consider taking the money you would have spent on closing costs on a new mortgage and putting it toward the principal on your existing mortgage. By pre-paying a few thousand dollars worth of principal, you will reduce your long-term interest costs because you'll be able to pay off your mortgage sooner. Again, you can use an online financial calculator to determine the long-term impact on your financial situation of prepaying some of your mortgage principal.
As an example, let's say you have a $300,000 mortgage at 6% interest. Over the life of the loan, you will pay a total of $647,515.44 if you make all 360 payments when they're due. If you were to refinance, your closing costs might be around $3,000, or 1% of the mortgage. If you took that $3,000 and paid it toward your principal in the twenty-fourth month of your 360 month mortgage, you would save $12,720 in the long run. This may not compare to the savings you'd achieve with refinancing, but if you can't or don't want to refinance, this is another option for reducing the long-term cost of your mortgage.
The Bottom Line
When market interest rates dip below the interest rate you're currently paying on your mortgage, refinancing can be a great way to save money. Just make sure you understand the math well enough to make an informed decision. (For more, check out 6 Questions To Ask Before You Refinance.)
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