When is a Good Time to Refinance Your Mortgage?

As we await a broad reduction in interest rates, many people continue to feel the impact of the significant jump in borrowing costs resulting from the Federal Reserve’s (the Fed) measures that have allowed the rate of inflation to return to more historical norms. A decline in interest rates can take longer than we would like, and it certainly seems to take longer for them to drop than it did for them to rise. This phenomenon has perhaps been felt the most in the real estate borrowing market, where mortgage interest rates remain close to double what they were before the Fed’s rate increases. As the Fed continues to hint at when they may begin to lower the Fed Funds Rate, we have started to see interest rates on mortgages begin to lower lately. I recently saw an article that threw out the question, “Is now a good time for homeowners who had purchased a home in the last year to consider refinancing those mortgages?”, in that rates have begun to drop. Knowing that all indications are that rates may continue to drop, it seemed a little premature to think about refinancing now, but of course, none of us has a crystal ball to know when rates will fall and how much they will fall. With that in mind, in this issue of the newsletter, we would like to dig a little deeper into the mortgage refinancing decision to look at how you might determine whether you ought to consider refinancing now or in the future.

Reasons to Refinance
It may seem obvious why you would want to refinance your mortgage, but there actually can be different reasons to do so. Lowering your interest rate, and thus your mortgage payment, is clearly the most common reason to refinance. However, if lowering your payment is your main objective, there are other ways to do that than just lowering your interest rate. For example, let’s say you initially took out an FHA mortgage, which has the additional cost for the mortgage of a Mortgage Insurance Premium (MIP) for the life of the loan. You may consider refinancing to a Conventional mortgage even though it may have the additional cost of Private Mortgage Insurance (PMI) because PMI can be removed from the mortgage payment once you have paid your loan balance down to the point where the loan amount is less than 80% of the purchase price. Depending on the amount of equity you have in your home, that reduction in fees could make your mortgage payment more manageable. Another reason to refinance could be to shorten the life of your loan. The majority of mortgages have a 30-year term. While you can make extra payments to shorten the life of the loan, typically the interest rate on a shorter term loan, like a 15 or 20-year mortgage, is lower than the rate of a 30-year mortgage. Thus by refinancing to a shorter loan, you could reduce borrowing costs even though the shorter term more than likely would increase the amount of your monthly mortgage payment. Because you would be making that payment for a shorter period of time, it could lower your out-of-pocket costs long-term. Then there is the consideration of locking in a fixed rate if you are currently in an Adjustable Rate Mortgage (ARM). ARMs have parameters for when they can change the interest rate, which gives you less certainty of knowing what the Principal & Interest (P&I) portion of your payment will be (if escrow payments that would include taxes and insurance are part of your mortgage payment, those are not fixed). If you want that certainty for the P&I portion of the payment and if rates have dropped since you took on the ARM, refinancing to a fixed rate might be an attractive option.

The Cost of Refinancing
In a vacuum, any of the reasons we discussed to refinance seem completely logical, especially if it is going to either lower your monthly cost or reduce your cost over the life of the loan. However, the act of refinancing requires you to close on a loan, and that results in costs that you will incur. The costs may not be as high as an initial mortgage closing, but costs still exist, and it is important to evaluate whether the benefits of refinancing outweigh the costs. Typically, in a refinancing situation, to avoid having to come out of pocket with funds, people will roll the cost of the closing into the new mortgage balance. In that scenario, you have by default increased the amount of the monthly note. The good news is that can spread the cost over the life of the mortgage, but the bad news is that you are also paying interest that additional cost for the entirety of the loan as well. With that in mind, if you are considering a mortgage refinance, it may be to your advantage to do some comparison shopping to determine the costs associated with the process for lenders you are considering using so you can make sure the costs you would have to pay are reasonable. Nevertheless, the other factors that result in lower monthly or lifetime costs can certainly be worthwhile, but the numbers have to be right, which is what we will look at next.

A Refinancing Example
Maybe the best way to illustrate how you may want to evaluate the numbers on whether it makes sense to refinance or not is by way of some examples. These examples are intended to provide a better understanding for common refinancing scenarios and are summarized in the tables below.

Scenario 1 – Desire to Lower Monthly Payment with a Lower Interest Rate
                                                                             Current Loan      Refinance Opt. 1     Refinance Opt. 2
Outstanding Mortgage Balance                     $250,000                      $257,500                    $260,000
Interest Rate                                                              7.500%                          6.500%                       6.250%
Remaining Payments                                                    350                                  360                               360
Monthly P&I Payment                                             $1,761                            $1,643                         $1,616
Monthly Mortgage Payment                                 $2,338                            $2,219                        $2,192
Total of Remaining Payments                         $818,147                       $799,004                   $789,242
Total Remaining Financing Cost                    $366,519                       $318,861                   $307,187
Reduction in Remaining Payments                                                          $19,143                      $28,905

In this scenario, the homeowner purchased their home with a 30-year mortgage near the peak of interest rates almost a year earlier and now that rates have declined, they are considering a refinance to lower their monthly payment. The interest rate they were quoted for a new 30-year mortgage was 1% below the 7.5% rate they locked in when they purchased, but they also got a quote to “buy down” the interest rate further for a larger amount of closing costs. With this refinancing approach, the mortgage term extends another 30 years vs. approximately 29 years left currently. This level of interest rate reduction lowers their mortgage payment by $119 to $146 per month, which over the life of the new loan lowers the amount paid out by approximately $20,000 - $30,000.

Scenario 2 – Desire to Lower the Financing Cost
                                                                             Current Loan     Refinance Opt. 1     Refinance Opt. 2
Outstanding Mortgage Balance                     $250,000                     $257,500                    $260,000
Interest Rate                                                              7.500%                        6.000%                        5.750%
Remaining Payments                                                    350                                180                                180
Monthly P&I Payment                                             $1,761                          $2,110                         $2,097
Monthly Mortgage Payment                                 $2,338                          $2,686                         $2,673
Total of Remaining Payments                         $818,147                     $483,430                    $481,116
Total Remaining Financing Cost                    $366,519                     $129,736                    $124,921
Reduction in Remaining Payments                                                      $236,783                    $241,598

This scenario puts a slight twist on the first one where the homeowner purchased their home with a 30-year mortgage near the peak of interest rates almost a year earlier; however, in this case, they are considering a refinance to shorten the loan term from roughly 29 years remaining to 15 years, which lowers the total cost of financing. As is the case with loans of shorter duration, the interest rate they were quoted for a this 15-year mortgage was 1.5% below the 7.5% rate they locked in when they purchased, and in this scenario they also got a quote to “buy down” the interest rate further for a larger amount of closing costs. With this refinancing approach, the monthly payment would actually go up by over $300 per month, but it would reduce the payment term by more than 14 years. This approach lowers the total financing cost by more than $230,000 over the life of the remaining loan.

Scenario 3 – Desire to Lower Monthly Payment by Removing Mortgage Insurance
                                                                             Current Loan     Refinance Opt. 1      Refinance Opt. 2
Outstanding Mortgage Balance                     $250,719                     $258,219                     $260,726
Interest Rate                                                               7.500%                        6.125%                       5.875%
Remaining Payments                                                     215                                216                               216
Monthly P&I Payment                                              $2,136                          $1,919                         $1,902
Monthly Mortgage Payment                                  $2,848                          $2,454                         $2,438
Total of Remaining Payments                          $612,395                     $530,070                    $526,523
Total Remaining Financing Cost                     $208,618                      $163,683                   $157,629
Reduction in Remaining Payments                                                          $82,325                      $85,873

This scenario requires more imagination and perhaps looking into the future, assuming that interest rates remain unfavorable for some time. In this instance, the homeowner purchased with a minimal down payment using an FHA loan at a 7.5% interest rate, but some 12 years later, having paid enough in to have reduced the loan balance to 80% of the original purchase price and in a more favorable interest rate environment, they are looking to refinance to a Conventional loan, which would allow them to stop paying the mortgage insurance as part of their escrow payments. In that they were almost 12 years into making payments, they did not want to go back to square one with a 30-year mortgage but also weren’t comfortable with a 15-year mortgage, so instead they chose a custom term of 18 years. By lowering the interest rate and eliminating the mortgage insurance from the payment, they lowered their total monthly payment by around $400 per month, which over the life of the new loan the amount paid out by more than $80,000.

While the examples presented all yielded favorable results, the level of favorability varied greatly. If you are considering refinancing, you should understand what you are trying to achieve with the refinancing and run the numbers to see if you are getting whaat you seek. While a better interest rate is valuable, it is not the entire story, so consider the bigger picture if you are thinking of taking that leap.

Stewardship Emphasis

The price you pay for something is important, but it is at least as important, if not moreso, that what you pay for has value in meeting your needs and objectives.

The Empowerment Channel    |   Volume CCXXVII   |    Dedicated to Promoting Financial Education through Stewardship