Refi or Not?

Richard Connor

MY WIFE AND I BOUGHT our first home in the mid-1980s. We were thrilled to get an 8% mortgage, though we had to pay three points—an upfront fee equal to 3% of the loan amount—to get that rate. Many of our friends had bought a few years earlier and were paying 14%, a common occurrence back then, according to Freddie Mac data.

We kept our eyes open for opportunities to refinance our high rate. If I recall correctly, the prevailing rule of thumb said you needed a two-percentage-point reduction in interest rate—and you might need to stay in the home for another seven years—for a refinancing to make sense.

How times have changed.

My son and daughter-in-law purchased a home in May 2019. Thirty-year mortgage rates were 4.125%. When my wife and I bought our current vacation house in November 2019, rates had fallen to 3.375%. Now, they’re down around 3%. At these low rates, the two-percentage-point rule no longer makes sense. A little internet research indicates that a one-point reduction is the new rule of thumb. What about paying points to get an even lower rate? You rarely hear about that these days.

There’s a number of reasons to consider refinancing—including these four:

  • Reduce your monthly payment. This is the No. 1 reason people refinance. A lower interest rate leads directly to a lower monthly principal-and-interest payment, assuming you opt for a mortgage of the same length.
  • Switch from an adjustable-rate to a fixed-rate mortgage. Adjustable-rate mortgages, or ARMs, can reset to a higher rate, sometimes leaving homeowners with payments they can’t afford. If you plan to stay in your home, you may want to refinance into a stable, fixed-rate loan.
  • Reduce the term of your mortgage. If rates drop enough, it may make sense to switch from a 30-year mortgage to a 15-year loan. Your payment will likely go up, but you can save huge amounts of interest and you’ll be mortgage-free far sooner.
  • Access your home’s equity. A cash-out refinancing lets you tap into your home’s equity by exchanging your current mortgage for a new one with a larger loan amount. You might use the extra money borrowed to pay off higher-cost debt, cover the kids’ college costs or remodel your home. If you’re paying off high-interest debt, such as credit card debt, make sure you don’t fall into old habits and quickly amass another pile of consumer debt.

A key question when deciding whether to refinance: When will you break even on the refinancing costs? The breakeven point is calculated by adding up all refinancing closing costs and then figuring out how many years it’ll take to recoup those costs through your new, lower monthly mortgage payment. One danger: You move within a few years—and never make back the cost of the refinancing.

Another pitfall: Let’s say you refinance your current 30-year mortgage, which you’ve had for five years, with a new 30-year loan. That means you’re signing up for five more years of mortgage payments—and you may end up paying more in total interest with the new mortgage. Ideally, when you refinance, you take out a mortgage that’s the same length or shorter than the number of years left on your current loan. It’s also important to shop around to find the best deal on both the interest rate and closing costs.

If you make a down payment of less than 20%, you’ll be required to pay private mortgage insurance (PMI), which shows up as a fee that’s rolled into your monthly loan amount. It protects the lender if you’re unable to pay your mortgage. You can typically get rid of PMI when your loan balance is less than 80% of your home’s current value.

Freddie Mac’s website says that monthly PMI can range from $30 to $70 per $100,000 of mortgage. The exact amount depends on several factors, including loan value, interest rate, loan term and, most important, down payment. For example, a $100,000 30-year mortgage, with a 10% down payment and a 4% interest rate, requires PMI of $59 a month. Make that a 15-year mortgage at 2.5% interest rate, and the PMI falls to $30 a month.

How do you decide whether refinancing makes sense? Consider the table below. We’ll assume an initial $100,000 mortgage, 30-year term, 4% interest rate and 10% down payment. The monthly principal and interest for this loan would be $477. At the end of the first year, the loan balance would be down to $98,239.

Let’s also assume that, after the first year, the available rates are 3% for 30-year loans and 2.5% for 15 years. Replacing the original loan with a new 30-year 3% mortgage adds one year to the term, but drops the monthly payment by $63, a savings of $756 per year.

Alternatively, if you’re able to handle a higher monthly payment, you could dramatically reduce the term of your loan and the total interest paid by switching to, say, a 15- or 20-year mortgage. Let’s say you exchange the original mortgage for a 15-year loan at 2.5%. The monthly principal-and-interest payment increases by $178 to $655, but PMI falls by $29, for a net increase of $149 a month.

Your closing costs will vary depending on the new loan amount, your credit score, debt-to-income ratio, loan program and interest rate. Closing costs can range from 2% to 6% of the borrowed amount. Pay careful attention to closing cost quotes. Your costs may include prepaid real estate taxes and homeowner’s insurance. You should recoup some of this as a refund from the escrow account for your original loan, but you’ll be out of pocket in the meantime. In our example, let’s assume closing costs are 3% of the loan amount, or $2,947.

The table summarizes the results. Note that simply dropping the interest rate by one percentage point saves almost $17,000 in interest over the life of the loan and it takes about four years for the monthly savings to cover the closing costs. Meanwhile, switching to a 15-year mortgage would save more than $48,000 in interest payments, while shaving 14 years off the term.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Working the NumbersSummer Job and Don’t Leave a Mess. Follow Rick on Twitter @RConnor609.

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