While it’s not necessary to watch interest rates with bated breath, it does make sense to keep an eye on what the market is doing and to know ahead of time what rate would trigger a situation where you should refinance your mortgage. So this begs the question, “How will I know when I should refinance?”
At What Rate Should You Refinance?
The first step in determining the right rate at which to refinance is to determine what your current mortgage is costing you overall and at what point a refinance would result in savings. There are many factors to consider including how long you plan to remain in your home, how long you have left on your current mortgage and whether you wish to pay points to secure a lower rate.
If you are living in your dream home and have plans of living there until your final days, then mortgage refinance at a lower rate of just 1 percent could result in savings. After a few years, the interest savings will cover the closing costs of the refinance, and after that point, you will begin saving money.
It’s easiest to look at it line item by line item with respect to mortgage costs. If John and Mary decided to refinance their $200,000 loan at 6% and 300 months remaining and found a loan of 5% for 30 years (36 months), they can compare the costs side-by-side to help them make a decision.
A new loan would cost John and Mary $2,200. To get the low 5% rate, they need to pay 2 points, or another $4,000. So the upfront costs on a new loan are $6,200. Upfront costs on the existing loan are zero. At this point, the existing loan is winning the race.
Now we will look at the total cost of each loan over the remaining period of each. The old loan has 20 years left on it or 240 months. Because you are stretching the balance of the loan over a longer period with the new loan, the new loan has lower monthly payments. But the total cost is quite different.
If John and Mary keep the new mortgage and see it through to the end of the 30-year term, they would end up paying $42,000 more Interest on the loan. But John and Mary can still take advantage of this lower interest rate by paying additional principle each month. The old loan costs them $1432 per month. The new loan only requires they pay $1,073 per month, but if they instead pay $1,320 per month, they will pay off the loan in the same amount of time and save $21,000 interest after upfront costs.
While there are other costs that come into play, such as difference in tax savings and lost interest on savings, it is unusual for these to be deciding factors. The real savings is in the interest and time period.
Smart Mortgage Refinance
The lesson here is that you are better off with mortgage refinance, but only if you pay off the new loan in the same period you would have paid the old one. In John and Mary’s case, the choice was simple. But had the refinance placed them in a position of paying PMI or had they rolled the closing costs into the new loan, savings would have been much less.
Now let us get back to the question at hand. How do you know when to jump in for a refinance? Your situation can be different, but for John and Mary, if they paid only closing costs to refinance ($2,200) did not pay points, and paid off the loan in 240 months, even a quarter percent can reduce their interest charges by almost $5,000 over the next 20 years. But after the reduced tax savings and value on interest of the $2,200 over 20 years, the savings is wiped out. That means John and Mary would have to wait for 5.5% to come along before jumping in to refinance.