Interest rates are constantly on the move. The rate on a 30-year fixed rate mortgage has moved lower since mid-December. This may create an opportunity to save money by refinancing. Here’s how to decide whether a refinance is beneficial.
Get a lower rate
This may seem obvious, but there is always the question of how much should you be able to lower your rate to benefit? Refinancing always involves certain costs, such as title, escrow and appraisal fees, and those fees can negate the benefits from a lower rate.
If you are considering a “rate-and-term” refinance—a loan whose sole purpose is to improve your rate—you should first consider how long you are likely to own the property. You should be able to recover the cost of the refinance and derive net savings from the lower rate.
To get an approximate idea of your savings, determine first what the cost of the new loan will be. The correct term is “non-recurring closing costs.” These are the one-time fees and expenses incurred in your refinance. Among these are title and escrow fees, appraisal, and lender underwriting and processing fees. There will be other costs involved, such as prorated interest and funding of a new impound account for taxes and insurance, but this is money that you would have paid even without the refinance.
Once you know the cost of your loan, calculate your monthly savings. To do this, multiply your current loan balance by the amount you expect to lower your rate. If your balance is $300,000 today and you can lower your rate by .625%, you would reduce your interest charges by $1,875 per year (300,000 x .625 = 1,875).
Next, divide the cost of the loan by your annual savings. This will tell you how long it will take to recover the cost of your loan. If your non-recurring closing costs are $3,750, you will recover your cost, or “break even,” in two years (3,750 / 1,875 = 2). From that time forward, you will be accruing net savings.
You may be able to get a rebate from your lender by selecting a higher interest rate. This rebate is the basis of a “no-cost refinance.” Keep in mind that you’ll have that higher rate over the term of your loan, so it may not give you the maximum savings if you plan to have the home for a long time.
To get the most benefit from a rate-and-term refinance, consider making the same payment as when your rate was higher. Doing this will shorten the term of your loan and avoid the “fritter factor,” where the monthly savings from the lower rate are simply absorbed into the household budget, never to be seen again.
Get rid of mortgage insurance
If you bought your home with a loan larger than 80% of its purchase price, you are probably paying mortgage insurance, typically referred to as “PMI” or simply “MI.” Lenders require this insurance to limit their exposure on a loan they consider to be risky. If you have a conventional loan with MI, you can ask the lender to remove it once you can prove that your loan is 80% of your property’s value or less. You’d do this with an appraisal, which costs about $500. You might choose this approach if you already have a rate close to the market rates available today.
With MI and a rate higher than the market rate, you may improve your position with a refinance. Use the calculation we mentioned earlier, but include the monthly MI premium in your numbers.
Many people bought their homes using a government-insured FHA loan. Those homeowners may not be able to get rid of MI; it will be in place for the life of the loan. If your property has risen in value, a refinance could save you some money even if your new loan is more than 80% of your home’s value. Replacing your FHA loan and its non-cancellable MI with a conventional loan whose MI can be removed can set you up for larger savings later, when your property has gone up in value and you can remove the mortgage insurance.
Getting cash out
If you have a lot of equity in your home, a refinance can convert some of it into cash. Many people refinance to consolidate and pay off consumer debt, such as credit cards. While the rate of a mortgage will almost certainly be much lower than any credit card, there are some caveats to keep in mind before committing to a cash-out refinance for this purpose.
If you are carrying high credit card balances, you are likely paying double-digit interest on them. Paying them off with a cash-out refinance will drop your payments dramatically. A $20,000 credit card balance will require a monthly minimum of about $600. The monthly payment on that portion of a mortgage is less than $100—a huge amount to save, right?
Not so fast. While you would be paying a lower rate, part of the reason for the reduction in your payment is the fact that you are stretching the repayment over 30 years. The total interest you’d pay on that 30-year loan would be over $16,000. If you decide to consolidate consumer debt with a mortgage refinance, consider making a higher monthly payment to reduce the interest expense. In this case, increasing the payment on your mortgage by $500 will retire that portion of your loan in just three years, saving you many thousands of dollars.
You should also take a hard look at your spending habits if you are considering a cash-out refinance for this reason. If you pay off all your credit cards with a mortgage, then accrue large balances again, you will not be improving your financial position. Use the refinance to get back on an even keel financially, and pay your credit cards off in full each month.
Today’s low rates create some opportunities to save. The knowledge you now have can help you to make the most of them.
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