Is Now the Time to Refinance Your Mortgage?

The economic upheaval we’ve experienced this year has led to at least one very positive outcome for U.S. consumers: Rock-bottom mortgage interest rates. If you’re planning to sell, you’re in luck as it is – at least here in the Atlanta area – a seller’s market. On the other hand, if you’re a buyer, low rates will be beneficial to you for years to come (we’ve written a bit more about purchasing a home and how it fits in your financial plan here).

The interest rate on the benchmark 30-year mortgage has been flirting with historic lows for months. It started the year at about 3.7% and dropped below 3% for the first time in July. After a brief uptick in August, it resumed its fall, dropping all the way to 2.8% in October.

Of course, low mortgage rates are great news for consumers. They enable homebuyers to get more house for their money or lower their monthly payment, freeing up cash for other purposes. Existing homeowners, meanwhile, can refinance their mortgages, potentially saving hundreds of dollars each month and thousands of dollar of interest expense over the life of the loan.

When Does Refinancing Make Sense?

If you are still sitting on the sidelines and wondering whether you should refinance your mortgage, there are several different factors you should take into consideration. The first is fairly simple: What is the difference between your current mortgage interest rate and today’s prevailing rates?

One rule of thumb is that you should strongly consider refinancing if you can lower your mortgage interest rate between 1 and 2 percentage points. So if your current rate is 4.5% and you can refinance at 3.0%, then refinancing could be smart.

Remember that you’ll have to pay closing costs (including prepayment of real estate taxes and other expenses) when you refinance your mortgage. Closing costs are the costs of refinancing and typically include origination fees, discount points and third-party charges like a home inspection, appraisal and title insurance fees that can add up to between 2% and 5% of your outstanding loan amount.

The next thing to consider is how long you plan to live in the home. The longer you stay in the home, the more time you’ll have to recoup your closing costs. For example, if your closing costs are $6,000 and your new mortgage will save you $200 per month, it will take you 30 months to recapture your closing costs and reach your break even point (6,000/200 = 30). If you’re pretty sure you’ll stay in the home for at least this long, then refinancing may make sense from a financial standpoint.

Also Look at Amortization

There’s another factor to consider when making the mortgage refi decision that isn’t quite as obvious. This factor has to do with the mortgage’s amortization schedule.

During the early years of a mortgage, the vast majority of the monthly payment goes toward paying interest instead of principle. This gradually shifts over the life of the mortgage so that during the latter years, most of the payment goes toward paying principle instead of interest.

When you refinance, the amortization clock resets and starts all over again. As a result, a higher proportion of your monthly payment will again be directed to interest payments instead of principal after you refinance. This could result in the payment of more interest over the life of the mortgage.

For example, suppose you are seven years into a 30-year fixed rate mortgage with an interest rate of 4% and your principal balance is $300,000. About $570 of your monthly payment now goes to principle and about $862 goes to interest. If you refinance into a new 30-year mortgage at 3.4%, about $480 of your monthly payment will go to principle and about $850 will go to interest.

In other words, approximately $90 less will be applied to your mortgage principle during the first month after you refinance. This will gradually increase over time, but the total amount of money applied to interest instead of principle during the first seven years of your new mortgage could be substantial.

Note, however, that the equation changes if you are refinancing from a 30-year mortgage into a shorter-term loan, such as a 15-year mortgage. Due to the shorter term, more of your payment will be directed to principal in the early years of this loan than would be the case with a new 30-year mortgage.

Do You Have an ARM?

Finally, if you currently have an adjustable rate mortgage (or ARM) or an interest-only mortgage, today’s ultra-low-rate environment offers perhaps a once-in-a-lifetime opportunity to eliminate the interest rate risk that’s inherent with these types of loans.

ARMs usually offer lower rates during the first few years of the mortgage before adjusting to reflect prevailing market rates. Since the rate on the 30-year fixed-rate mortgage is so low, the ARM doesn’t offer much a savings now anyway.

With an interest-only mortgage, meanwhile, you only pay interest during a fixed number of years. After this, your monthly payment converts to principal and interest, which usually boosts the payment amount considerably. Refinancing to a 30-year fixed-rate mortgage now could save you from monthly payment shock later.

To Refinance or Not to Refinance

Deciding whether or not to refinance ultimately comes down to closing costs, savings on monthly interest payments and whether or not you’ll save on total interest over the course of the loan. Reducing the amount of interest you pay and understanding your options to reduce property taxes – we’ve written about homestead exemptions in Atlanta and Decatur here – are concrete steps you can take to improve your financial picture.