The Federal Reserve has been using a set of monetary strategies called quantitative easing (QE) to artificially keep interest rates extremely low across the entire United States economy. Interest rates on savings accounts, auto loans, and mortgages have been pushed down to historic lows. The average interest rate for a 30 year fixed rate mortgage recently got as low as 3.31%. The 15 year mortgage average dropped down to 2.62%.
Every time mortgage rates take a significant drop due to economic or monetary policy reasons there is a big push from mortgage lenders and brokers encouraging everyone to refinance their home mortgage. While refinancing can save you money in the long run it doesn’t necessarily make sense to refinance every single time mortgage rates drop. How can you know when to refinance and when to stick with your current mortgage?
7 Factors to Consider About Refinancing When Mortgage Rates Drop
When the headlines constantly read of dropping mortgage rates it can be tempting to drop your current mortgage in favor of a freshly refinanced loan in order to enjoy the cheapest rates around. Before you drop everything to run to the nearest mortgage broker office, here are some factors to consider.
1. Your Current Mortgage Rate
Is your current interest rate on your home mortgage competitive with the rates you can refinance into? Or are you paying well above the current market rates?
The difference can make or break the decision to refinance your mortgage. If you are enjoying a mortgage that is 0.25% off from current refinancing rates it probably doesn’t make financial sense to refinance. (You should run the numbers through a mortgage refinance calculator to make sure.)
However, if you are currently paying an interest rate that is higher than current rates by 0.50% or more you should definitely look at refinancing your mortgage loan.
2. Your Current Mortgage Term
Another big factor to consider is your mortgage’s length and how many years are left on it. If you are 3 years away from paying off your home then it likely won’t make financial sense to refinance. Your payments toward the end of the mortgage are mostly principal instead of interest, so any drop in interest rate would be minuscule.
However, if there is a significant amount of time on the mortgage then the savings in interest should be able to net you lower costs overall even after taking closing costs into consideration.
3. Your Credit Score
When you see headlines about mortgage rates in the 2.75% to 3.5% range you might be quick to rush out to refinance.
Unfortunately, those listed rates are only for borrowers with the best credit scores and credit history profiles. If you have poor credit it is unlikely you will be approved for the best rates. Your credit score might result in a rate that is 1% or 2% higher than the historical low rates making refinancing a non-option for you.
4. Closing Costs on a Refinance Loan
How much you pay in closing costs directly determines whether or not refinancing makes sense for you. Even if you qualify for the best rates you have to do some math to determine if refinancing makes sense.
For example, let’s say you can refinance to a loan that will save you $360 per year in interest ($30 per month). If the closing costs on the loan are $1,000 then it will take you just under 3 years of lower interest costs to pay for the closing costs, so refinancing probably makes sense. If your closing costs are $3,600 you will need to live in the property for 10 years before you earn a “profit” on the lower interest rate. That might make refinancing less appealing.
5. How Long You Plan to Live in the Property
As discussed above, how long you plan to live in the home you refinance directly impacts the viability of refinancing your home loan. If you plan to be in the home for several decades then it makes sense to refinance even when it will take many years to recoup the closing costs. As long as you will eventually come out ahead with the interest savings then it is a smart financial move.
The opposite is true if you are only planning to live in the home a few more years. You would have to have a massive amount of interest savings (or close to zero closing costs) to have any refinance make sense.
6. Do You Have a Prepayment Penalty?
Most mortgages post-housing crash do not have a prepayment penalty, but if you are still locked in to one from many years ago it can make refinancing difficult. The prepayment penalty would have to be calculated in just like a closing cost to determine whether the lower interest you pay would make up the difference.
For example, let’s say you can refinance into a loan that will save you $1,000 per year in interest that comes with $3,000 in closing costs. You are looking at breaking even after 3 years and coming out ahead in the years after that by $1,000 per year. However, your current loan has a prepayment penalty equal to 2% of the original loan amount of $160,000. That’s $3,200.
Instead of breaking even at the end of year three ($3,000 in closing costs divided by $1,000 per year saved in interest) you now don’t break even until after six years. You are covering the $3,000 in mortgage closing costs plus $3,200 in prepayment penalty for a total of $6,200 in costs associated with your refinance. Even though you’re saving $1,000 per year in interest it won’t be until year 7 that you actually save money on the refinance. If you plan to be in the home longer than that, refinancing is a wise choice.
7. How Much Will Refinancing Save You?
The bottom line is you must calculate not only how much you will save each month on a refinance but comparing the cost savings to the expenses you incur to refinance the loan. The mortgage broker commercials you hear on television and radio ads tout the benefits of saving hundreds of dollars per month in interest. That sounds great, but if the amount you save will never cover your closing costs then you shouldn’t refinance. Likewise if you won’t live in the home long enough to recoup the savings from the refinance, then you shouldn’t refinance.
It isn’t as simple as saving $50 per month on your loan payment. You have to look at the bigger picture and run some simple calculations to determine if you should refinance when mortgage rates drop.