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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:
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 Numbers, Summer Job and Don’t Leave a Mess. Follow Rick on Twitter @RConnor609.
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I haven’t had luck refinancing. I’m retired living off my investments but in the U.S. underwriting guidelines seem require a fixed stream of income, from a job, or from setting up an annuity under same underwriting guidelines, which I don’t want to do. A fixed stream of income counts for everything and net worth counts for nothing, which makes no sense to me. I can just pay it off, and may, but I like the additional liquidity and it is still cheap money I can invest at a higher return elsewhere.
We have refinanced several times over our years of home ownership, with a variety of purposes. Current rates look very inviting.
We have 23 years left on our mortgage, and we are looking at both 15 & 20 year refis. The advantage of the 20 year is that monthly payments remain about the same (as our youngest starts college this year, and we’ve worked hard to free up cash flow for tuition and related costs), and knocking 3 years off our payment schedule. The issue with the 15 is that despite an 8 year improvement in loan life that will help our net worth & reduce costs during early retirement, the higher monthly payments will hurt short term cash flow.
Much like deciding how much to save for retirement, a refi is very much a struggle between financing the now, and financing the future. Future me wants a 15 year refi, but current me wants to maintain a cash flow cushion until my son is close to graduating.
Mortgages fit in one’s asset allocation as negative bonds, a thought worth considering.
On refinancing, it’s helpful to subtract the closing costs from the amount borrowed to calculate the actual interest rate you’re paying. With the nominal 3% 30 year example it’s 3.24%, with the nominal 2.5% 15 year example it’s 2.93%.
A third alternative is to stay with the current loan and up the monthly payments to $727 to reduce the payoff period to 15 more years. Interest savings would be $35,671 and you avoid closing costs.
A fourth alternative to save more is to take the 30 year refinance and pay that off in 15 years.
A voluntary 15 year payoff on a 30 year loan allows you to reduce payments to the standard amount in hard times, providing a nice bit of flexibility at the price of a bit more interest than a standard 15 year loan.
I’ve heard some mortgages include evil prepayment penalties, so look into that no matter what you do.