With record low interest rates many people have been asking themselves lately if it makes sense for them to refinance their home mortgage. A rule of thumb that’s often thrown around is that if you can refinance and lower your mortgage interest rate by 1%, then you should consider doing so. As with many personal finance rules of thumb, this generalization leaves out too many other factors that should be used to guide your decision making. Here are some guidelines to help you figure out if refinancing your mortgage makes sense for your personal situation.
How Long Are You Going To Stay In Your Home?
The first question to take into consideration when determining whether or not you should refinance your mortgage is how long you are going to stay in your home. The reason that determining how long you’re likely to stay in your home is important is because it helps you to determine if you will break even on the costs associated with refinancing your mortgage before you sell your home.
If you don’t at least break even on the costs of the refinance, then there isn’t really a point of doing so. Closing costs can range from 2-6% of your loan balance and paying thousands of dollars to lock in a lower interest rate doesn’t make sense if you’re going to sell your home before you break even. In other words, how long would it take to recoup the cost of refinancing with the savings of the lower payment?
Calculate The Break Even Point
Here’s an example of how to calculate the break even point to see when you recoup your refinance closing costs.
Current mortgage:
- Balance = $200,000
- Interest rate = 4.25%
- Principal & Interest Payment = $983.88
New refinanced mortgage:
- Closing costs = $6,000 (3% of loan amount)
- Balance (closing costs rolled into loan) = $206,000
- Interest rate = 3.25%
- Principal & Interest Payment = $870.41
In this example, the closing costs of $6,000 were rolled into the mortgage (most people do this rather than pay those costs out of pocket) and the principal and interest payment of the mortgage went down by $113.47 per month due to a 1% lower interest rate.
With this information, we can determine the simplest way to tell whether you should refinance your mortgage. If we take the closing costs of $3,000 and divide that number by the decrease in the mortgage payment of $113.47 per month (in other words, monthly savings of $113.47), then we can see that it would take 26.4 months to break even on the closing costs (see below).
So, if you are not going to stay in the home for at least 27 months after you refinance the mortgage you will not recoup the closing costs that you paid for the refinance. Remember that this is simply the point that you’re breaking even – you haven’t actually saved any money yet at this point.
$3,000 Closing Costs / $113.47 Monthly Savings = 26.4 Months to Break Even
You could take this a step further and calculate the internal rate of return on the monthly cash flow savings that you would receive from the refinance, but this is probably too complicated and nerdy for most people to care.
Are You Going to Extend Your Term?
The example above assumes that the new mortgage will be refinanced back to a 30-year term. Shortening the length of the term by just 5 years to a 25-year mortgage would increase the monthly payment to $974.63, or a monthly savings from the original mortgage payment of $9.25. With a monthly savings of $9.25 you wouldn’t break even on the refinance costs of $3,000 until over 324 months (27 years). However, there’s potential that opting for a shorter mortgage term could result in a lower interest rate.
While refinancing to a shorter mortgage term will help you pay your home off faster or in the same amount of time that you were set to pay it off before the refinance, we can see that it can significantly decrease the monthly cash flow savings and extends the break even point. This is why it’s important to run the numbers and weigh the pros and cons of each situation rather than refinancing just because you can decrease your interest rate by a certain percentage.
Do You Have An Adjustable Rate Mortgage (ARM)?
If you have an Adjustable Rate Mortgage (ARM) and you plan to live in your house for a long time, then it may make sense to refinance to a fixed rate mortgage. An ARM is a type of mortgage where the interest rate can change throughout the life of the loan. For example, a 5/1 ARM has a fixed interest rate for the first 5 years of the loan (the “5” in the 5/1) with a variable interest rate that adjusts every year thereafter (the “1” in the 5/1).
People will often choose an ARM over a fixed rate mortgage because the interest rate will be lower. However, the downside is that if you plan to live in the home for longer than 5 years (in this example), then your interest rate could continue to increase.
Given that we are in a period of historically low interest rates, this could be a concern for those who plan to live in their homes for a long time. In this case, locking in a low fixed interest rate over a long loan term and not having to worry about the rate adjusting up at some point in the future may be beneficial.
Do You Have Mortgage Insurance?
Private Mortgage Insurance (PMI) is often required by lenders when you put less than 20% down on a mortgage. This insurance helps to protect the lender in case you do not make your payments.
If you have a conventional mortgage, then your lender is supposed to cancel your PMI once your mortgage balance is decreased to 78% of your home’s value (also known as loan-to-value or LTV). However, you also may be able to request that the PMI is dropped once your mortgage hits 80% by contacting your lender.
Unfortunately, this is not the case for FHA loans which are required to carry a different type of mortgage insurance (called qualified mortgage insurance premium or MIP) throughout the life of the loan, depending on when it was taken out. If you’re in this scenario where you have MIP on a FHA loan, then it may make sense to refinance your mortgage to a conventional loan if you are able to get to 80% LTV and not have to pay PMI on the new loan. A decrease in your interest rate can also help to justify a refinance in this scenario.
Just like you can run a break even analysis with the savings generated from an interest rate decrease, you could do the same thing with the monthly savings of not having to pay mortgage insurance. Keep in mind that PMI can be dropped off at 80% LTV for a conventional mortgage, so this may not be as beneficial to refinance in this scenario if your loan with PMI has a low interest rate and the PMI will be dropped soon.
Should You Refinance Your Mortgage?
Whether or not you should refinance your mortgage all comes down to making an educated guess on how long you will stay in your home and actually running the numbers. Simply refinancing because you can decrease your interest rate by 1% or because a lender is pushing you to lock in a “record low rate” isn’t enough. As with all financial decisions, you need to take your own personal situation into account and determine what’s right for you.
