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Mortgage interest rates have recently dropped to record lows, leaving many homeowners wondering “should I refinance my mortgage?” For many, the answer is likely to be “yes”, but there are many considerations in deciding if refinancing is right for you.
Figure out How Much you Could Save
Mortgage rates at the end of April surpassed record lows achieved in 2012, with the average 30-year mortgage rate falling to 3.23%. Mortgage rates continue to hover near these levels, making now a particularly attractive time to refinance. To understand approximately how much interest can be saved per month, take your (current mortgage interest rate – expected new mortgage rate) x current mortgage balance.
For example, let’s assume the following:
Current Interest Rate: 4.50%
Expected New Interest Rate: 3.375%
Current Loan Balance: $250,000
Approximate Interest Savings/Yr. = (4.50% – 3.375%) x $250,000 = $1,875 (or approximately $156/mo).
In reality, savings will be a bit less, as the loan balance shrinks every month.
Determine Closing Costs to Refinance Your Mortgage
When you refinance your mortgage, you’ll end up paying a number of fees, such as:
- Origination Fees
- Title Fees (title search, title policy, legal fees, etc.)
- Credit Report, Flood Certification, etc.
Some costs can be negotiated with the lender, while others are considered “fixed.” For example, many lenders often charge hefty origination fees. These, however, can often be negotiated to help reduce your closing costs, and thus reduce the time to “breakeven” on the refinance. The simplest way to understand what can be negotiated is to ask the lender what fees go to them vs. what fees go to 3rd parties (i.e. for services they are paying for, like credit reports). If you can find a lender that charges minimal origination fees, you can save thousands in closing costs.
In addition to the closing costs, there are a number of pre-paid expenses at closing. You may end up prepaying for:
- Homeowner’s Insurance
- Property Taxes
The prepaid interest is often confusing to borrowers. Think of the interest in a simple manner: you will be paying interest every day regardless of the day you refinance. If you refinance on June 10th, you’ll pay your old lender interest up until June 10th and your new lender thereafter.
The biggest takeaway is to recognize which ones are true costs (origination fees, title fees, etc.) and which are simply pre-paid expenses (insurance, taxes, etc.). The savings of achieving a lower interest rate need to offset the true costs of the transaction.
Understand the Cash Flow Impact of Refinancing
One question I often get is how it works to “skip” a mortgage payment. In reality, you’re never skipping any payment, but you may be paying cash at different times. Let’s look at two examples:
If you close June 10th, for example, you likely will not have paid the June mortgage payment, as there is typically a 15 day grace period. If you close on the 10th, you’ll owe the old lender interest from May 1 – June 10th (interest is paid in arrears). Then you’ll prepay the new lender interest from the 10th to the 30th at closing, and your first mortgage payment will be on August 1st. So while it may seem like you skipped your mortgage payments for June and July, you’re really just paying at different times.
If you close June 20th, you likely will have paid your June mortgage payment so as to avoid late payment penalties. Therefore, at closing you will owe your old lender interest from June 1st to 20th and your new lender from the 20th through the 30th. You’d only be “skipping” July, and your first payment would be due August 1st.
Even though you’ll be paying costs out of pocket at closing, not having to make a mortgage payment the month following closing often helps offset some of this cash outflow.
Should I refinance my mortgage?
Understanding whether to refinance your mortgage doesn’t have to be complex. Just use a simple formula to see if it makes sense for you. Take the true closing costs and divide by the approximate annual savings. This will tell you approximately how many months it will take to breakeven on your refinance. While it’s not a perfect formula, it is a pretty good indicator of whether you should refinance. For example, if the breakeven time is 12 months and you plan to stay in the house for 5 years, refinancing is almost certain to be the better choice.
While no one knows whether rates are going to go up or down, mortgage rates are at historically attractive levels, making now perhaps the best opportunity to date to consider refinancing. If you’re curious about mortgage rates relative to historic levels, check out the St. Louis Fed’s mortgage rate tracker.
There are many other reasons to refinance, but saving on interest is perhaps the most popular reason. For now, if you’re looking to save on overall interest paid, there isn’t a better time to look into refinancing your mortgage to see just how much you can save!
Have you refinanced recently? Let me know in the comments below!