With prevailing rates hovering near 8% as of the end of October for a conventional 30-year mortgage, a common question many homeowners face is when, and whether, to refinance their mortgage.
What is refinancing, anyway?
Refinancing your mortgage works like refinancing your student loans or any other type of debt: You acquire new debt to pay off your old debt.
For example, a cash-out refinance involves replacing your existing mortgage with a mortgage loan for a higher amount, and pocketing the difference after subtracting out the transaction closing costs. The new mortgage amount minus closing costs is the amount available to pay off your existing mortgage:
new mortgage amount – closing costs – existing mortgage balance = cash to borrower
For example, assume you obtain a new mortgage for $330,000 and incur $10,000 in closing costs. You have $320,000 available to pay off existing debt. If your mortgage balance is $280,000, you will receive the $40,000 difference in cash when closing the transaction.
On the other hand, if the new mortgage minus closing costs is less than the existing balance, the “cash to borrower” is a negative number using the above formula. In the latter scenario you will have to pay that difference in cash to close the transaction.
Whether refinancing is a good idea depends on your particular situation and what you hope to achieve.
Why do people refinance their mortgages?
The two most common reasons that homeowners refinance their mortgage are to obtain a more favorable interest rate or tap into their home equity with a cash-out refinance. Homeowners also refinance mortgages to reduce the mortgage term (for example, switching from a 30-year mortgage to a 15-year mortgage), lower their monthly payment, or remove an owner from title to the property (for example, under the terms of a divorce settlement). You can target multiple objectives simultaneously. Some objectives tend to pair well together, like reducing a mortgage term and obtaining a lower interest rate, since lenders often offer lower interest rates for shorter terms. However, there are often tradeoffs among the most sought after objectives, so knowing which reasons are the most important to you will facilitate your refinancing decision.
Lower interest rate
If you obtained your mortgage when interest rates were high, you might have purchased the home with the intent of refinancing your mortgage when interest rates later dropped. Nobody can accurately predict the future, but refinancing too soon can be financially counterproductive.
A companion reason to seeking a lower interest rate is replacing an adjustable-rate mortgage with a fixed-rate mortgage to reduce uncertainty in future mortgage payments.
Access home equity
Homeowners often tap into their home equity via a cash-out refinance. Sometimes they do this in conjunction with lower rates or reducing their mortgage term, but other times they simply need the cash—for example, to pay medical bills, send a child to college, upgrade the home, or pay off non-mortgage debt—and home equity is the best (or perhaps only) option.
This may not be avoidable, but do not view your home as a piggy bank.
Shorter term
All else being equal, a shorter term will result in a lower interest rate, but also a higher monthly payment. Even with the same rate, a shorter term will result in you paying much less in interest over the long run. Returning to our above example, the new $330,000 mortgage might incur a 7.25% rate over a 30-year term but a 6.625% rate over a 15-year term. The payment on the 30-year note would be $2,251.18 (principal and interest only), while the payment on the 15-year note would be $2,897.38 (principal and interest only). If you could find the extra $646.20 in your budget, you would pay off the loan in half the time and save hundreds of thousands of dollars in the process.
Even if the 15-year loan in this example had the same 7.25% rate as the 30-year loan, the monthly principal and interest payment would be $3,012.45. Over a 15-year span, those payments would total $542,240.55—more than a quarter million dollars less than stretching the loan out over thirty years. What would you do with an extra quarter million?!?
Remember that you can always make extra payments towards your principal balance. This could be a viable alternative to refinancing. For instance, if you paid an extra $761.27 per month on the 30-year note above—only about one-third more—you would pay off the loan in fifteen years instead of thirty. (If you were lucky enough to obtain a mortgage in early 2021 when interest rates were under 3%, though, you would be better off investing that extra money each month versus paying off your mortgage early since the rate of return on your investment would exceed the interest rate on your mortgage.)
If you plan to sell before paying off the mortgage, the difference in the total amount paid will not be as striking, but the notion that you pay less over time with a lower rate and/or a shorter term still holds true.
Lower monthly payment
You can obtain a lower monthly payment with a lower interest rate, a longer term, or both. If interest rates are the same, the longer term will reduce your monthly payment. But because you will be paying for a longer time, you will pay much more over the long run.
How can I tell if refinancing makes sense for me?
You would be hard-pressed to find a better interest rate than your existing mortgage right now (unless you can switch from a 30-year term to a 15-year term), but that has not always been the case, and might not be the case in the future.
A particular lender can tell you the current interest rates on mortgages it originates. The interest rates I used above, for instance, were the rates available from Navy Federal Credit Union (where we have our existing mortgage) for conventional fixed-rate mortgages on the day I wrote this. An independent broker can obtain quotes from multiple lenders on your behalf, which can save you time versus contacting several potential lenders. Quotes should include the interest rate plus all estimated closing costs.
You will incur similar closing costs on a refinance transaction that you did when you purchased the property. After all, the new lender still needs to assure that you hold good title to the property, will be able to make the scheduled payments, and own a home that holds a high enough value and is insured against loss or damage. You are essentially “buying” your existing home from yourself.
If you stick with the same lender you might be able to save on a lot of the costs because the lender already knows you.
Beware of advertisements that offer “no-cost” refinances. You will usually incur the same closing costs, but simply wrap them up into the new loan so you have no out-of-pocket costs at closing. This means you are effectively borrowing money to pay the closing costs.
Once you know the closing costs, compare your current and potential new mortgage payments. Do this with the principal and interest portion only, because you will have tax and insurance expenses regardless of your mortgage terms (and even when you have no mortgage at all!). If your new mortgage payment is lower, divide the closing costs by your monthly savings. The result will tell you how long it will take to recoup the costs of refinancing from a monthly cash-flow perspective:
For example, if you incur $7,500 in closing costs, and your monthly savings (i.e., the difference between your current mortgage payment and new mortgage payment) is $150, it will take you 50 months to recover your costs before you start actually saving money.
Now consider your timeframe. If you expect to sell or refinance again before the end of the recovery period, then refinancing now will end up costing you more than sticking with the status quo. Do not refinance.
Comparing your monthly cash flow is a quick way to gauge the financial wisdom of a potential refinance, but it has its limitations. The actual computation is more complicated because a cash-flow analysis does not consider the term or size of either the new or existing mortgage. For instance, your new mortgage might have a higher monthly payment, even with a much lower interest rate, if you shorten the term.
A general rule of thumb is that refinancing makes sense if you can get an interest rate that is at least 1–2% lower than your current rate. Otherwise, the costs of refinancing will not be worth the savings.
Step-by-step approach
If you want to be more exacting, do the following:
Use an amortization calculator to chart out your payments under both your existing mortgage and potential new mortgage. (You can also create your own in Excel or Google Sheets.) Remember, you are concerned with principal and interest only because taxes and insurance apply regardless of your mortgage.
Add up the total interest you will pay under your existing mortgage until the time you expect to sell or refinance again.
Add up the total interest you will pay under your potential new mortgage until the time you expect to sell or refinance again.
Add your expected closing costs to your result from #3.
If #4 is higher, you will pay more to borrow money with refinancing versus the status quo. Do not refinance unless there are other considerations. (For example, perhaps you need to do a cash-out refinance, and the extra cost you will pay for refinancing is worth the tradeoff.)
If #2 is higher, you will save money by refinancing. Congratulations!
Use my spreadsheet instead!
To compare your existing mortgage to a potential replacement mortgage and make the right refinancing decision for you, use my Google Sheet. To use your own numbers, open the sheet, select “File,” and then select “Make a Copy” to create your own copy where you can edit the numbers however you wish. It goes through the above steps for you!
For your existing mortgage, enter the current balance, remaining term in months, and annual interest rate. Do the same for your potential new mortgage, plus the expected closing costs. I provided a sample comparison, but change the green fields to fit your own situation! (Only change the fields highlighted in green.)
The spreadsheet will populate an amortization schedule for each loan. It will also calculate the total interest paid over time under each scenario, add the expected closing costs to the new mortgage, and give you the difference in borrowing costs between your existing mortgage and potential new mortgage.
The “month” is expressed in months from now. For instance, month 48 shows you the status of each mortgage after 48 months of payments—in other words, four years from now.
Scroll through the difference column and see the ranges where it is positive and negative. Compare it to your expected time frame of when you would likely sell or refinance again. If the difference is positive, it costs you more money to refinance now than to keep your existing mortgage if you sell the property or refinance again after that many months. If the difference is negative, then you will end up saving money by refinancing.
The interesting part about the comparison is that it might cost you more to refinance unless you plan to hold onto the new mortgage long enough, save you money in the long run if you stick with the new mortgage for a certain number of years, but then cost you more again if you plan to stick with it for too long. When making the comparison, be realistic about your future plans, and consider other tradeoffs such as your monthly cash flow.
Assume that someone is four years into a 30-year mortgage—so they have 312 months remaining—that has a current balance of $450,000 at a 7.5% interest rate. When rates fall to 6.25% they consider refinancing since they are now in that “1–2%” general-rule-of-thumb range. They do not have the funds to pay the $12,500 in closing costs out of pocket so they would roll that into a new 30-year mortgage at the lower rate. In other words, they would borrow $462,500 at 6.25% for 30 years.
I included this scenario as an example in the spreadsheet. Notice that the “difference” column is positive for months 1–31, negative for months 32–348, and positive for months 349 onward. This means that if they sold or refinanced again within the next 2 ½ years, refinancing now would cost them money; otherwise, they would save money in the long run unless they sold in the final year of the new mortgage. (This is largely because the existing mortgage would be paid off after 312 months, but they would have to continue paying on the new mortgage for 48 more months.) You can also see where the long-term savings from refinancing is probably not worth the effort after three years (36 months) but starts to make a significant difference in years five through seven (months 60 through 84), which is why you often hear that refinancing is counterproductive unless you plan to stick with the new mortgage for at least 5–7 years.
This comparison only measures the cost of borrowing—i.e., the interest paid and the money you spend on closing costs (whether paid out of pocket or included in the new loan). Do not compare the principal balance remaining at any point because you already received value for any difference in the beginning principal amounts. For example, you might have a higher beginning balance with the new mortgage because you needed to borrow to pay the closing costs or pursued a cash-out refinance. On the other hand, you might have a lower beginning balance after paying extra at closing.
What about PMI?
Private mortgage insurance, or PMI, is not included in this analysis. For conventional mortgages, PMI is based on your loan-to-value ratio. You can ask your lender to cancel the PMI when your loan-to-value ratio is less than a specified percentage (usually 80%). While you can drop your PMI by refinancing, there are other ways, such as making extra principal payments and/or ordering a new appraisal.
If you have an FHA loan, you typically cannot drop your PMI without refinancing.
However, if dropping or reducing PMI is part of your calculus, add your monthly PMI cost to your interest paid for each month that PMI will apply as part of steps #2 and #3 above.
What else?
The key variable is your timeframe until you plan to sell or refinance again. It does not matter whether you live in the home or rent it out because you will still be responsible for paying the mortgage. If you are unsure about your timeframe, or have only a vague idea, reviewing the trend in the “difference” column in my spreadsheet can be particularly helpful in deciding whether refinancing makes long-term financial sense.
As always, though, personal finance is personal. There are often compelling non-financial reasons for certain decisions. It might be worth taking a financial hit, for instance, to keep your kids in the same home following a divorce. Once you have a clear understanding of all the ramifications of your different options, you will be able to make the right choice.
Comments