With interest rates at historic lows, many homeowners are considering refinancing their current mortgage. But making the decision to refinance or not can be tricky given the costs involved. Here are some factors to consider when considering a mortgage refinancing (“refi”).
Is It Worth It?
The decision to refinance comes down to evaluating the benefit of the overall savings over the life of the loan against the costs of the refi, which typically run at about 1.5-2% of the loan amount, or even higher.
An approach to evaluating this tradeoff is to calculate a payback period, which is defined as the number of months it takes for the refi savings to cover the refi costs. One rule of thumb says that a refi is worthwhile if the payback period is 30 months or less.
This is just a rule of thumb, however, and the refi decision needs to take into account the borrower’s specific situation. For example, a borrower who plans to live in their home for the next two decades may be okay with a longer payback period, while another borrower who plans on moving within the next few years will require a much shorter payback period.
But it also depends on calculating the payback period correctly. The simple payback formula of dividing the refi costs by the monthly savings often fails to produce a fair comparison between the existing mortgage and the proposed refi. A better approach considers both the change in payments and the projected change in mortgage balance. In a future article, we will demonstrate how to correctly calculate a payback period.
Should you Reduce the Term?
One common strategy when considering a refi is to reduce the term of the loan. For example, a borrower with a remaining term of 25 years might consider refinancing into a 20-Year mortgage. In many cases, the payment will still be lower even with the shorter term. But is it always a good idea to reduce the term?
It is important to remember that a borrower can always choose to reduce the term by making extra payments, but they cannot extend the term without refinancing. Therefore, the advantage of a longer mortgage is flexibility. This flexibility can be very valuable if the borrower’s cash flow situation unexpectedly changes.
On the flipside, mortgages with shorter terms such as 20, 15, or even 10 years, typically carry lower interest rates. This opportunity to reduce the rate even further with a shorter-term mortgage needs to be considered alongside the need and preference for flexibility. Ultimately this decision depends on each person’s specific situation.
Mortgage rates can also differ based on the size of the loan. Currently, “conforming” loans have a limit of $510,399, while any loans above that amount are considered “jumbo”. Rates on conforming loans tend to be less than those on jumbo loans. Therefore, a borrower who is refinancing and is close to the jumbo/conforming threshold may want to consider paying down their mortgage to qualify for a conforming loan.
Another option open to borrowers is to “buy down” the interest rate by paying “points”. Points are a fee paid to the mortgage originator, and typically one-point equals 1% of the loan amount. A mortgage company might typically offer a .25% reduction in the interest rate for each point purchased. For example, one point ($1,000) on a $100,000 loan could reduce the interest rate from 4% to 3.75%.
The decision to pay points brings us back to the payback period calculation, but the payback period on rate buydowns is usually beyond the 30-month rule of thumb. Therefore, it usually only makes sense to use this strategy when there is a high likelihood that the mortgage will be in place for a long time.
As you can see, there are many considerations to keep in mind and alternatives to consider when evaluating a “refi” opportunity. The right decision will not solely depend on interest rates and refinancing costs. The decision to refinance, informed by a properly executed analysis, will largely depend on the circumstances and objectives specific to you.