Mortgage rates are on the rise. As reported by the New York Times, rates jumped 50 basis points virtually overnight. My own tracking of rates confirms the jump, as reflected here. And this raises an important question–when should you refinance a mortgage?
The common reason to refinance a mortgage is because rates have gone down. This in turn raises the question of just how much lower rates must be to justify the refi. We’ll answer this question below, and look at three other good reasons to consider a mortgage refinance.
Interest Rates Have Gone Down
The primary reason many homeowners refinance their mortgage is to lower their interest rate. It’s why we refinance just about any loan, whether it’s a mortgage, student loan, or even credit card debt (think 0% balance transfer cards). According to the White House, the average homeowner could save $3,000 a year by refinancing their mortgage.
As you evaluate whether lower rates justify refinancing, consider the following:
- While rates have ticked up, predicting future interest rates is a fool’s errand. Most predict that rates will rise over the coming months and years, and I agree with this assessment. I also thought the Indians would win the World Series. The point is that you should evaluate whether to refinance a mortgage based on today’s rates, not a prediction of future rates.
- How much you’ll save each month is a function of more than the interest rate. Mortgage brokers often tout the lower monthly payment, but keep in mind that the lower payment is also a function of the term of the new loan. If you have 20 years left on your mortgage and refinance back to a 30-year mortgage, the extended term will lower your monthly payment even at the same interest rate.
- It’s important to factor in the tax consequences of a refinance. Lowering your interest rate saves money, but perhaps not as much as you may think once you adjust the lower interest payments for the smaller tax deduction.
And that brings us to the question of just how much lower must rates be to justify refinancing. There are numerous “rules of thumb” that range from 0.50% to as high as 2%. A better approach is to do the math. It takes just a few steps:
- Determine how much in interest you’ll save each month (this number goes down as you pay down your mortgage, but as a rough estimate for a long term mortgage the first month’s savings can be used);
- Reduce the interest savings by your marginal tax rate to adjust for the smaller tax deduction (this only applies if you itemize your tax deductions);
- Determine the total cost of refinancing your mortgage (your bank or mortgage broker can provide this information); and
- Divide the total cost of the refinance by your monthly after-tax savings.
The result is the number of months it will take you to reach the breakeven point. If you plan to stay in the home longer than the breakeven point, refinancing makes sense. Here it’s important to focus not just on the interest rate, but also on the cost of refinancing.
For example, I spoke with the folks at Rocket Mortgage about refinancing costs. Here’s what they told me: “QL [Quicken Loans] origination cost is typically $1,049, that is the only flat charge that is consistent. Everything else would be based off of Fannie and Freddie pricing adjustments surrounding the areas such as credit, Loan-to-Value, and debt-to-income (as DTI can dictate which programs you may qualify for).”
If you didn’t follow all of that, you’re not alone. The mortgage business is complicated. The key is to get firm cost estimates from multiple mortgage lenders before making a decision.
Your Credit Score Has Gone Up
Even if rates haven’t gone down, you still may be able to qualify for a lower rate if your credit score has improved. According to myFICO, current mortgage rates can vary by as much as 1.50% based on your credit score. On a $300,000 mortgage, a 1.50% higher mortgage rate due to a mediocre credit score will add more than $250 a month to your mortgage payment.
To qualify for the best mortgage rates, aim for a FICO score of 760 or higher. If you don’t know your score, there are several ways to get your score for free.
You Need To Lower Your Monthly Payment
In extreme cases, you may need to refinance your mortgage to lower your payments, even if you can’t reduce your interest rate. By refinancing your mortgage to a term that is longer than what’s left on the mortgage, you can reduce your monthly payments.
For example, after paying on a $300,000 30-year fixed rate mortgage for ten years at an interest rate of 4.00%, the outstanding balance will be about $235,000 (according to my favorite mortgage calculator). The principal and interest payments on this mortgage come in at about $1,430. By refinancing the outstanding balance of $235,000 back to a 30-year fixed rate mortgage, the payments drop to about $1,120 even at the same interest rate.
There’s no magic here. You’ve simply added back another ten years of payments to your mortgage at the same interest rate. It’s not advisable because you end up paying a lot more in interest due to the additional decade of payments. But it does lower your monthly payment which may be helpful in extreme circumstances.
To Convert An ARM To A Fixed Rate Mortgage
Finally, refinancing can make sense as a way to convert an Adjustable Rate Mortgage (ARM) to a fixed rate mortgage. This is particularly true if you believe interest rates may be on the rise. In the personal finance Facebook group I run, a member recently asked about this very issue involving a 7/1 ARM at 3%.
He’s faced with a tough decision. Does he stick with a 7/1 ARM at 3% until the interest rate adjusts at the end of year seven? Or does he refinance now and lock in a good rate by historical standards that is a bit higher than three percent? What makes this decision so difficult is that there’s no way to know what interest rates will look like when the ARM’s rate adjusts.
In these circumstances I’m a big believer in a bird in the hand is worth two in the bush. It’s certainly possible that rates could be lower several years from now then they are today. But given historical trends, it’s unlikely. Regardless, the current 30-year fixed rate hovers between 4% and 4.5%. And that’s after a sharp and quick rise of 50 basis points, as reflected in this chart from Freddie Mac:
For me, I wouldn’t bet on rates staying low. If I financed a property with an ARM, I’d be looking to refinance fast.