Should I Refinance my Home?

With a long-term home mortgage, interest rates matter.  Rates on home mortgages have dropped about 20% in the last year, making this a good time to look at your mortgage to see if you can save some money.  With rates at less than one-half their long term average of about 8%, homes have never been so affordable.  The low housing inventory, though, is causing some people to stay in their current home longer.  Housing starts, a popular economic indicator, fell for the second straight month in June and building permits dropped to a 2-year low.  This is a direct result of labor shortages and high home construction costs.  If this has you rethinking a move to another home, consider the cost savings of a mortgage refinance.

The chart below shows 30-year mortgage rates since 2000.  As of this writing, the current 30-year mortgage rate is 3.6%, compared to 4.52% last year.  With a drop like that, it can make sense to refinance even if you bought your house a year ago.

Why Refinance?

A 1% reduction in interest rate will result in big-time cost savings over the life of your mortgage.  For example, a couple borrowing $200,000 at 4.7% over 30 years and refinancing 3 years later at 3.7% for 30 years will save nearly $21,000 over the life of the mortgage.

Here are some of the most compelling reasons to refinance an existing mortgage when interest rates decline:

• Reduce your monthly payment
• Shorten the mortgage term (ex., go from 30 to 20 years) with potentially the same monthly payment
• Cancel mortgage Insurance if home equity is at least 20% of home value
• Combine two loans into one: Pay off a high interest rate HELOC by combining with a 1^st mortgage
• Convert from an adjustable rate mortgage to fixed rate

How should I start?

Start by knowing your credit score, which we explained in our blog HERE.  Scores of 740 and higher fall into the same tier.  The lowest rates will be offered to those with credit scores above 740 and equity in their homes of at least 25%.  Banks and other lenders sell most of the mortgage loans they issue to Federal government agencies Fannie Mae and Freddie Mac, so they follow Fannie’s and Freddie’s guidelines on credit approval.  In turn, Fannie and Freddie bundle these purchased mortgage loans into mortgage-backed securities that are sold to investors.

Next, compare interest rates and closing costs offered by different lenders.  Ask family, friends and advisors for recommendations.  A lender should be able to give you a ballpark rate and fees based on the credit score you provide.  You will want to limit the number of actual mortgage applications to 2 in order to minimize the negative impact on your credit score.  A mortgage application will result in the lender pulling a full credit report and background check, known as a “hard” inquiry that deducts points from your credit score.  Beware that applying for a mortgage and a car loan at the same time can be a problem.

Closing costs and fees should be considered in relation to your monthly savings as explained below.  Here is a list of some, but not all, possible costs your lender may charge: application fee, appraisal fee, origination fee, document processing fee, underwriting fee, credit report charge, title search, title insurance, recording fee and others.  It is not unusual for these costs to add up to $2500 or more.  You can pay them outright or add them to the mortgage balance.

Do the Math

Really, it’s easy.  A general rule of thumb often used is to refinance if the interest rate drops by 1%.  But do the math.  You can easily do a simple payback calculation using this formula:

Fees + closing costs     /      Monthly savings        =         Number of months to breakeven

Compare the result to how long you expect to live in your home.  After you breakeven, the additional savings are a true boost to your cash flow.  If you are in your forever home and are considering shortening the mortgage term, ask your lender to provide an analysis of the interest cost savings.

Refinancing a home mortgage should be considered given the recent improvement in interest rates.  The extra money in your bank account can be put towards savings goals like retirement or children’s education, and will help you build your net worth faster.