Since its recent peak of roughly 3.25% in November of 2018, the yield on the U.S. 10-year Treasury note has steadily fallen to a mid-October level of around 1.75%. While this is higher than the all-time low of 1.32%, the current rate is significantly lower than the long-term average. Fixed-term mortgage rates tend to have a high correlation with the movement in this yield figure, so a lot of homeowners could potentially benefit from refinancing the mortgage on their primary residence. According to Black Knight’s Mortgage Monitor, over eight million homeowners could both qualify for a refinance and also benefit from a lower rate.
A good strategy for analyzing the mortgage refinancing decision is a simple cost-benefit analysis: will the savings from my refinance outweigh the time, effort, and money required to execute it? On the benefit side, the main reason most people choose to refinance is to lock in a lower interest rate. Whether this new rate results from a decline in general financial market interest rates like we are seeing now or from homeowners wanting to change to a shorter loan term in order to pay off the balance faster, the lower rate is a primary driver for the refinancing decision. Take, for example, a homeowner with a new $500,000 mortgage being charged a fixed 5% interest rate over a 30-year term. The monthly payment would be $2,684, of which over $2,000 would be interest cost paid to the bank. As the balance declines, the portion of each payment that covers the interest cost will go down but the initial years of mortgage payments are very interest-heavy. The average 30-year fixed rate today is about 3.75%, so a refinance of $500,000 in mortgage debt would lower the monthly payment by over $360 to $2,316. In addition to a lower payment, the interest portion of that first payment is only 68% of the total as opposed to 78% in the more expensive mortgage. Not only will you be paying less per month, but a larger dollar value of principal will be applied to the loan balance, increasing your equity in the property.
While a lower interest rate and monthly payment may sound appealing, there are multiple costs you must take into consideration before pulling the trigger on a mortgage application. First, the lender you are using will want to pull your credit report. This may result in a slightly lower credit score for a while compared to not having applied for a refinance. However, you are afforded a two-week window to shop around for a mortgage during which multiple credit report pulls will not continue to ding your score. Second, there is considerable time and effort required to gather all the documentation required for the application. The lender will likely require documented income and tax history, statements for all investment/retirement accounts, proof of insurance, and more for each borrower. With hectic personal and professional schedules, a lot of borrowers don’t consider the interest savings worth more than the time required to achieve them. Lastly, there can be significant financial cost to refinancing. Some mortgage lenders will charge points (a fee determined as a small percentage of the loan amount) in order to secure the advertised interest rate. There will also be title service and recording fees, an appraisal charge to examine the value of the subject property, and additional origination fees charged by the loan originator. Altogether, these costs can prove significant and may require several years of lower interest cost to recoup. According to Lending Tree, the closing costs for a refinance range from three to six percent of the loan amount with a national average of $4,876. This varies significantly by location and lender so be sure to request a cost estimate when applying for your loan. In the example above, this national average cost would take just over a year to recover via lower interest payments.
There are additional facets of your loan to consider before starting the refinancing process. If you have been making mortgage payments for several years, refinancing into a new loan with the same length will extend the “finish line” date for owning your home outright. While you will likely pay less in total interest cost, the mental burden of carrying a mortgage—potentially into retirement—may not warrant starting over with a new loan. Alternatively, if you have paid down a significant portion of your balance, you may be able to refinance into a shorter-term loan (such as moving from a 30-year fixed into a 15-year fixed) with a similar monthly payment, depending on the remaining balance and how much lower the interest rate is. Also, if you are currently nearing the end of a rate lock for an adjustable-rate mortgage (i.e. six years into a seven-year ARM), refinancing at today’s low rates could prevent your current loan from having a floating rate moving forward.
Another aspect to consider is how long you plan to stay in your home. It takes time for the monthly interest cost savings from a new loan to cover the upfront monetary cost of the refinance. If you are going to be selling the property within a few years, it would be very difficult to recoup your refinancing expenses in that short period of time.
As you can see, there are a lot of factors at play when considering if it makes sense to refinance a mortgage. While it is great to pay less interest to a lender, there are many costs to overcome in order to come out ahead on the transaction. Please contact your financial planner at Moller Financial Services if you need any advice on this complex decision.
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