One More Time

Submitted by Guy Williams on October 23, 2019

Interest rates are falling. This is unusual in periods of low unemployment and economic growth. So, what does this unusual pattern mean to you?

If you owe money, this is a great time to look at refinancing. Mortgage loans are the first place to look for refinancing opportunities. Rates for 30-year mortgages are in the mid 3% range and 15-year mortgages are available in the low 3% range. If you have an adjustable rate mortgage, this is a great time to switch from a floating rate to a fixed rate.

There is a simple way to determine if refinancing makes sense. First, compare your old payment amount to the new payment amount. Once you know the difference in payment amounts, look at how much it will cost to refinance. This the total amount paid to the mortgage company and will include the appraisal and all closing costs and fees.

Once you know how much it will cost to refinance, you can calculate a breakeven point. By taking the monthly savings on the new loan and dividing it into the cost to refinance, you can calculate the number of months it will take before the reduced payment covers the cost to refinance.

For example, imagine that you owe $200,000 on a 30-year mortgage loan at 4.5% interest. Your payment before escrow for taxes and insurance would be $1013.37. If you can secure a 3.5% rate, your new payment would be $898.09. The difference between the two payments is $115.28. If the total cost to refinance is $2,000, the breakeven is 17.35 months or slightly less than a year and a half. Interestingly, if you leave the payment the same and reduce the term, your 360-month loan turns into a 295-month loan. You will be paid off five years sooner.

If the number is 36 or less generally the refinance option makes sense. Of course, if you expect to sell or move before the three-year period passes, refinancing would be a losing proposition.

If you determine that you will be in your house for a while and that the breakeven is below 36 months, then refinancing is probably a good idea.

The common recommendation is that you look at shortening the term of your loan. For example, if you have a 30-year loan, it may be possible to shorten the term to 25 years and keep the same payment amount. The reason that we recommend shortening the term is that the future is uncertain. With a shorter-term loan, you will pay down principal more quickly and will reach the point of owning your home free of debt sooner. Owning your home free of debt is a worthy financial goal that also provides peace of mind.

As attractive, as refinancing might seem there are a few circumstances in which it may not be the best option. The first is expected time before you may sell your home. The sooner you plan to sell, the less sense refinancing makes. Another obstacle to refinancing is credit score. If your credit score is declining, you may be ineligible to refinance or the cost may be prohibitive. If you have a low or declining credit score, ask your mortgage lender or local bank to help you understand the steps that are necessary to improve your score. This will help you to receive better options in all future credit situations.

If you have a low loan balance (generally less than $100,000) it also may not make sense to refinance since the costs are relatively fixed and you will not be able to spread them over a big loan. If you have a low loan balance you should still use the refinance math, but do not be surprised if the numbers do not work. The reason that smaller loans are harder to refinance is that the fixed costs of refinancing is a bigger percentage of the loan balance.

Finally, it isn’t generally recommended to cash out refinances in which you increase your loan balance. Getting out of debt as soon as possible is a worthy financial goal. Take advantage of the new lower rates. This can also work for other fixed rate loans, so don’t be afraid to ask your lenders for a rate reduction. Interest rates are unusually low now, but cannot be counted on to remain there for a lengthy time.