When should I refinance my mortgage loan?

This article will ... Review what goes into mortgage interest rates. Look at when it may make sense to refinance a mortgage loan. Look at some of the costs … and long-term items … that can factor into the decision.

Refinancing a mortgage loan can potentially help homeowners reduce their monthly payment, especially when interest rates fall substantially, but it is also often costly.

Lenders typically charge borrowers from 2 percent to 6 percent of their principal (loan amount) in closing costs, which covers the appraisal, origination fees, attorney fees, underwriting fees, credit report check, and title services, among other expenses.¹ On a $400,000 loan, that amounts to fees of $8,000 to $24,000.

As such, it is important that homeowners ask the right questions and perform a cost-benefit analysis before they choose to refinance their mortgage loan. Depending on the terms of their loan and their unique financial circumstances, it may make sense to wait for rates to fall further.

Here’s a closer look at everything homeowners need to know about refinancing, including:

• What determines their interest rate
• When it might pay to refinance a mortgage loan.
• How much it costs.

What determines your interest rates?

Mortgage rates are determined by economic factors including inflation, the bond market, and decisions made by the Federal Reserve. The 30-year mortgage rate is closely correlated with the 10-year Treasury note.

The interest rate that homeowners ultimately pay, however, is also dictated by:

• Their credit history: Those with a higher credit score typically receive the most favorable loan terms. (Learn more: Improving your credit score: It pays off)
• Their down payment: Borrowers who come to the closing table with a down payment of at least 20 percent often receive a lower interest rate. Why? They have a larger equity stake in their home which reduces risk to the lender. They also eliminate the need for private mortgage insurance (PMI), an additional monthly fee required by lenders when borrowers put down less than 20 percent of the home’s value.
• The size of their loan: Very small loans and so-called “jumbo loans” can trigger higher interest rates than conforming or mid-sized loans because they are considered by lenders to be higher risk.
• Your loan type: Adjustable rate mortgages, ARMs, often offer a lower initial interest rate for a set period of time, say, 5 or 7 years. But payments could potentially rise significantly if interest rates climb thereafter. A fixed-rate mortgage, by contrast, may come with a higher interest rate, but it offers payment predictability because the interest rate is set for the entire length of the loan, often 15 or 30 years.

When to consider refinancing

Homeowners refinance their loans for a variety of reasons. They may wish to:

• Lower their payments: If current interest rates are sufficiently lower than their existing mortgage rate, refinancing can reduce their monthly payments and the total interest they will pay over the life of the loan.
• Shorten their loan term: Refinancing to a shorter term can help homeowners pay off their mortgage faster and save on interest, though it may increase their monthly payments.
• Consolidate debt: Homeowners can potentially consolidate their loan by taking out a new, larger loan using their home equity to pay off smaller, high interest debts, such as credit cards or student loans, at a lower monthly payment. But that involves risk. Because they are moving unsecured debt (credit cards) into a secured loan (mortgage), they risk losing their home if they cannot keep up with payments.
• Remove private mortgage insurance (PMI): If they have built up enough home equity, either by paying down their principal or through price appreciation, that they now have at least a 20 percent equity stake, refinancing can help them remove PMI and reduce their monthly payments.
• Change loan type: Switching from an ARM to a fixed-rate mortgage could potentially provide stability and payment predictability.

When should homeowners consider refinancing their mortgage loan?

Before refinancing their mortgage loan, homeowners should consider how long they plan to remain in their home and how much they can potentially save, said Daniel J. Drabinski, founder and chief executive officer of Integrated Strategies in Dallas, Texas.

“A general rule of thumb is that if you have plans to remain in the home long-term, and can refinance your current rate by at least 75 basis points to 1 percent of the loan amount, it may make sense to consider a refinancing assuming the closing costs add up,” he said.

Basis points are used to describe changes in interest rates or fees. For example, a rate drop of 75 basis points, which is sometimes considered the “sweet spot” for refinancing, refers to 0.75 percent of one percent. (i.e. your interest rate drops from 6.5 percent to 5.75 percent)

“Another thing to consider is whether your personal credit score has improved since you initially took out the loan, thus enabling you to you potentially secure a better rate,” said Drabinski.

The Breakeven Point

A cost-benefit analysis can be easily done by determining the breakeven point, or the time it takes for the savings from refinancing to cover the costs associated with the process.

“When determining whether to refinance one’s mortgage the most important factor is to calculate your break-even point and evaluate whether the change aligns with your long-term goals,” said Drabinski. “If you plan to stay in the home longer than the break-even period, refinancing generally makes sense.”

To calculate the break-even point, follow these simple steps:

1. Determine the monthly savings: Subtract your new monthly mortgage payment from your current monthly payment.
2. Calculate the total costs: Add up all the costs associated with refinancing.
3. Divide the total costs by the monthly savings: This will give you the number of months it will take to recoup the costs.

Here’s an example:

• Your current monthly payment is $1,500.
• Your new monthly payment after refinancing would be $1,300, for a $200 monthly savings.
• If your total refinancing costs were $3,000, then your breakeven point would be 15 months. ($3,000/$200 = 15)

In this example, it would take 15 months for the savings from the lower monthly payment to offset the refinancing costs. If you plan to stay in your home longer than 15 months, refinancing could be a financially sound decision.

Beware the cost of extending your loan term

Beyond the closing costs involved, which are widely disclosed, Drabinski warned that refinancing a mortgage loan may also involve long-term costs, especially if you extend the term of your loan.

For example, you may be able to lower your monthly payment by starting your loan term over 30-years, but you will also likely increase the total interest you will pay over the life of the loan, even with a lower interest rate. That’s because you will be paying interest for more years.

You aren’t compelled to lengthen the term of your loan, of course. Talk to your lender. They may be able to offer a custom loan term that mirrors your current term, say, 21 years.

“As a general rule, look at switching from a 30-year to a 15-year mortgage if you’d like to pay off debt quicker and save on total interest, and extend to a 30-year mortgage if you wish to reduce monthly payments and improve near-term cash flow, with full awareness that you may be paying more in total interest,” said Drabinski.

When not to refinance your mortgage loan

Borrowers should always consider the remaining term on their loan before embarking on a mortgage refinancing, said Corey Schneider, a financial professional with Sentinel Solutions in New York City.  

“You could have a really high interest rate, but if you are far enough into your loan that you are now paying a large portion of each payment toward principal, you may not benefit from refinancing,” he said. ”At that point you are no longer paying a significant amount of interest on your loan. People always forget that.”

Indeed, most traditional fixed-rate mortgages are structured so that the bulk of a borrower’s monthly payment is applied to interest in the beginning of their mortgage term when their loan balance is high. The percentage of their monthly payment that gets applied to principal gradually climbs over time until their final payments are almost exclusively applied to principal, a process known as amortization. 

Conclusion

Refinancing your mortgage when interest rates drop can be a wise financial move under certain conditions, depending on your current loan terms and what you wish to achieve.

A financial professional can help you determine when the time is right and whether a lower interest rate today may help you reach your short- and long-term goals.

Discover more from MassMutual…

How to refinance your mortgage

Pros and cons of an adjustable rate mortgage

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