When interest rates were at all-time lows during 2020 and 2021, about 14 million borrowers, or one-third of all mortgages, were refinanced. Refinancing allowed these buyers to reduce their interest rates and therefore their monthly payments. Some also extended the loan term or did a cash-out refinance, which allowed them to take a lump sum from their home equity.
Refinancing during this time was an easy decision, with rates below 3%. In the current market, with rates still over 6%, it is a more difficult decision. How do you know when is the best time for you to refinance a mortgage? There are many factors to consider, which we explore in depth during this blog post:
Current interest rates
Your loan terms, including whether you have a fixed- or adjustable-rate mortgage
Changes in your financial situation
The amount of equity in your home
How long you plan to stay in your home
Costs of the refinance
Interest Rate Considerations
In general, you might consider refinancing when you qualify for an interest rate 1-2 percentage points lower than your existing mortgage. The smaller percentages can be especially helpful if you have a large loan balance, as it can significantly reduce your monthly interest payments.
Your lender will be a great resource for you to get an idea of the current refinancing market. They can provide you with information on rates and closing costs. You can also check current rate averages on websites such as Bankrate or FreddieMac and enter your information in a mortgage refinance calculator before starting the conversation.
Improvements in Your Financial Situation
Credit scores have a significant impact on mortgage rates. This is especially true for conventional mortgages, while scores have less impact on rates for FHA, VA, and USDA loans. A general guide for ranking of scores is as follows:
740-plus is generally considered excellent credit
700-739 is considered good credit
630-699 is fair credit
629 and below is poor credit
Even a half percent in rate offerings, which could be the difference between good or excellent credit, can add up to a lot more interest over the loan’s life.
An improvement in your debt-to-income ratio can also be beneficial because it shows that you’re a less risky borrower and more likely to make your monthly payments.
How much difference can half a percent make on a 30-year, $400K loan?
A 5% rate would lead to $337K of mortgage interest over the 30 years.
A 5.5% rate would lead to $417K of mortgage interest over the 30 years.
That’s $80K of savings from only half a percent!
If your financial situation has improved since you originally got your mortgage, such as paying down credit card debt or increasing your income, refinancing may be attractive.
Home Equity and Its Role in Refinancing
It will come as no surprise that improved equity in your home can lead to better refinancing terms. It is another factor that can show the lender you are a less risky borrower. Most lenders even require private mortgage insurance (PMI) if you borrow more than 80% of the value of your home.
This insurance affords you no protections. Instead, it protects your lender if you don’t make your payments.
If your home has increased in value when you proceed with your refinance, a nice benefit can be to get rid of your PMI payments! An increased value will improve your loan-to value ratio and put money back in your pocket each month if it gets you below the PMI threshold.
Changing the Loan Term
One of the options that will be presented to you with a refinance is to change the term length of your loan. The most common loan is 30 years, but some who are aggressive about paying down debt opt for 15 years. How do you decide which to choose?
Depending on the rate offering, you can typically earn more money by choosing the longer-term option and investing the difference in the market vs. putting your refinance savings back into your mortgage. Ara breaks down the math in his blog post about biweekly mortgage payments. However, many people aim to go into retirement debt-free, including mortgage-free.
Let’s say you have 20 years left on your mortgage. If you refinance into the 15-year term offering for a better rate, your monthly payment might stay similar and will put you on track to pay off your mortgage five years sooner.
If you make the opposite choice and refinance into a 30-year, you’re stretching out your remaining loan term by 10 years. But you’re also likely significantly reducing your monthly payment, allowing you to invest the excess or meet cash flow needs during difficult times.
In short, the math typically says to opt for the longer-term option and invest the savings, but our life choices aren’t always so cut and dry. There can be a psychological benefit to getting rid of debt, and it’s also an “out of sight, out of mind” benefit for those who struggle with spending habits.
Converting from an Adjustable-Rate Mortgage to a Fixed-Rate Mortgage
Along with changing the term length on your mortgage, you may look at refinancing to change from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage. Oftentimes, homebuyers will consider an ARM when rates are higher than they’re comfortable with and the ARM offers a lower rate for the beginning years before it’s subject to adjust. Homebuyers may also consider one if they know they plan to move before the rate starts adjusting.
When rates decline or the adjustable portion of the mortgage approaches, homeowners may consider refinancing into a fixed-rate mortgage to avoid the uncertainty of future increases. If life circumstances change and they now want to stay in the home long-term, they should also consider refinancing into a fixed rate when either of these circumstances is true.
ARMs can be a great product for a specific buyer, but interest rate changes, especially on larger loans, can render monthly payments unaffordable for some people. A fixed-rate mortgage offers a steadier monthly payment without fear of future rate changes.
Cash-Out Refinance: Tapping into Your Home Equity
Most of what we’ve discussed so far has been around refinancing strategies that aim to save you money, but that isn’t necessarily the case when it comes to a cash-out refinance. With this type of refinancing, you actually increase your mortgage balance and take the difference between the pre-refinancing mortgage and the new mortgage as a cash payment. The amount will be limited by the typical factors, such as your loan-to-value ratio and financial situation.
A major reason a homeowner may go this route is to fund large home renovations. It will give you cash in hand that can fund your project, all at a likely lower fixed rate than a personal loan or a HELOC. Some also take these loans out for debt consolidation or to fund other significant expenses like a college education. It can allow you to finance these debts at a lower overall interest rate. Still, the negative aspect is that your home becomes the collateral for items that may have otherwise been a lower-priority debt in terms of collections or bankruptcy.
Calculating the Break-Even Point
With any refinancing decision, it’s important to consider how long it will take to recoup the closing costs. This period is considered the break-even point. The calculation is fairly simple: You will divide the cost of refinancing by your monthly savings, and the end result is the number of months it will take to break even.
As mentioned, knowing how long you plan to stay in your home is an important part of the refinancing decision. For example, if your break-even point is 36 months and you plan to stay in your home for only the next year, it probably won’t make sense to proceed with the refinance.
Say Greg and Sue purchased their home last year for $800K and took out a 30-year, $640K mortgage at 7%. Their monthly principal and interest payment is $4,258. The current mortgage balance is $620K, and they’ve been making extra payments due to the interest rate.
They’ve recently gotten a refinancing offer for 6% and $3K in closing costs. Their principal and interest payment on a 30-year, $620K mortgage would be $3,717 for a monthly savings of $541. How long does it take to break even?
$3K closing costs / $541 = ~5.5 months
If Greg and Sue plan to stay in their home for at least the next six months or so, this refinancing offer could certainly make sense for them. They may hold off if they think they will qualify for a better rate in the near future.
Timing the Market
Many homeowners struggle with the decision to refinance in a declining-rate environment because they are always waiting for the next best thing. It can be difficult to lock in a new mortgage rate when you hope rates will be even lower in a year. As with trying to time the market and missing out on investment gains, you could miss out on hundreds of dollars of monthly savings by holding out for better rates. What if they go up? What if they decline by only a small amount?
There are always expert opinions on what will happen to the mortgage rate environment, but they are not always correct. If the refinancing offer makes sense for your financial situation and your plans to stay in your home, then it should be considered even if you think rates will drop further in the next year or two. You are not limited to only one refinance in your lifetime! If rates take another significant drop, you can always refinance again.
Refinancing costs can be somewhat of a barrier in these situations because they extend that break-even timeline. However, some lenders offer no-cost or low-cost refinances that could make sense in these situations. The rates may not be as competitive as some of the higher-priced refinances, but the break-even point could make more sense, particularly if you plan to refinance again later.
Refinancing your mortgage once, let alone twice, can be a daunting undertaking. It is a lot of paperwork to put together! But, in a declining-rate environment where rates are still higher than modern averages (the past 10 years), it should be considered as a plausible strategy.
Understanding the Costs of Refinancing
Refinancing closing costs have been mentioned several times in this article, but how much is typical, and are there any other fees involved?
The cost to refinance can vary greatly based on your lender, location, mortgage balance, occupancy type, and other factors. The general rule is that it costs anywhere from 2 to 6%. Many lenders will roll the costs into your new loan balance so that you don’t have to pay them out of pocket at closing.
These closing costs bundle several different fees, such as:
Application fee
Origination fee
Credit report fee
Home appraisal
And many others
Some may be paid before closing, but most are paid at closing. While the out-of-pocket outlay can be significant, costs will all be factored into the break-even analysis, and it can still be advantageous if the rate is appropriate.
Conclusion
Overall, there are many factors to consider when refinancing, such as your financial situation, the current rate environment, and how long you plan to stay in your home. Having a relatively clear picture of your goals and plans is important before jumping into a refinancing decision since it has upfront costs.
It is always a good idea to shop around for multiple refinancing offers before committing to one since they can vary greatly by lender. Your current mortgage lender will not always give you the best offer, although they are incentivized to try to keep you as a client.
As always, when making any big financial decision, consult with your financial advisor about your options.