Interest rates on mortgages have declined again. Is this a good time to refinance your mortgage? What if I told you that you could save $50,000 simply by refinancing your loan.
There is a general rule of thumb. If the interest rate drops by one percent or more, you can probably save money by refinancing your loan. Here’s a chart depicting the movement of the 30-year mortgage interest rate since the beginning of 2012.
As you can see, during 2013 the interest rate jumped from about 3.5 percent to about 4.5 percent. Since that peak, mortgage rates have been on a steady decline and have fallen back to those levels not seen since early 2013. So if you secured a mortgage late in 2013 and are paying around 4.5 percent, you could probably save money by refinancing your loan now as interest rates have fallen about one percent. The current rate, according to bankrate.com is 3.45 percent.
Let’s assume that you bought a house in August 2013 for $400,000. You put down 20 percent — or $80,000 — and financed the remaining $320,000 with a 30-year fixed rate mortgage for 4.50 percent. Your monthly payment is about $1,623 per month.
For the past three years, you have been paying your mortgage each month. Now, with interest rates a full point lower, you could save a fair amount of money on your mortgage each month. If you were to refinance your loan, you could lower your monthly payment by about $250. That’s a lot of money. Refinancing your home could lower your housing (mortgage only) costs by about 15 percent. This is certainly something worth considering.
Before you call your mortgage broker and start the paperwork, I want you to consider the negatives as well. For one thing, refinancing is not free. Your costs usually run about $3,000. Luckily, your lender won’t expect you to pony up that money, instead they’ll just add it to the principal that you are borrowing. The monthly mortgage differential is relatively negligible.
Using our example, where the homeowner borrowed $320,000 at 4.5 percent, after three years, you would still owe about $304,000 on your loan. (Remember, the lender gets paid back disproportionally in the early years of the loan.) When you refinance your loan, the lender would roll that $3,000 in closing costs into your loan, so your new loan would be for $307,000. A new 30-year loan at 3.5 percent would result in monthly payments of $1,379 — that’s $245 less than your old payment.
So the good news is that you are spending a lot less each month. The bad news is that you just extended your loan by three additional years. By taking out a brand new 30-year loan, you reset the settlement date. Your old loan which you started in 2013 would mature in 2043. If you refinance your loan in 2016, that new loan wouldn’t mature until 2046.
Some people think that the three additional years is immaterial, but delaying your payoff date makes it harder for you to have your loan fully paid off by the time you retire. One of your biggest goals should be to be debt free — including your mortgage — by the time you retire. Imagine trying to continue making mortgage payments when you don’t have an income any longer, except for Social Security.
Refinancing once or twice early on in your loan may not be too detrimental to your long term plans, but some people are serial refinancers. If you continually refinance your home to a new 30-year loan, you will almost certainly still have a mortgage payment after your reach your retirement age. That in-and-of-itself may be the primary reason that you need to continue working past your retirement age.
Save $50,000 and pay off your loan 7 years earlier
I like the idea of lowering your monthly fixed expenses, but here are two alternative approaches. One option would be to refinance your loan to a new 30-year loan, but continue making that same payment from the original loan. Again, using the same example, your new 30-year loan would decrease the monthly required payment from $1,621 to $1,379. My suggestion would be that instead of taking that $245 each month and spending it frivolously, why not continue making that same $1,621 payment. The overpayment on your loan serves to prepay the loan.
By simply continuing to make the same monthly payment you will save almost $50,000 over the life of the loan and shorten the loan by 7 years. Refinancing your loan today could decrease — not increase — the amount of time that you are borrowing money from the bank simply by prepaying the loan.
The trick here is that you have to over pay the loan each month. The tendency is to just pay the minimum that you have to. In this instance, you have been paying $1,623 for the past three years. If you just keep paying that $1,623 from your original loan on your new loan, you could have that loan paid off by 2039.
- The original loan from 2013 was slated to mature in 2043.
- The refinanced loan today would mature in 2046.
- By prepaying the new loan, you could have it paid off 7 years early — that’s 4 years earlier than the original loan — in 2039.
- And prepaying the new loan would save you almost $50,000 in finance costs
Your specific situation will be different, but this illustrates the savings that you might see.
As an alternative to getting a new 30-year, you could get a shorter loan. The rates on 15-year loans have come down as well, but your monthly payments on a 15-year loan will likely be higher. The current rate on a 15-year loan is just 2.72 percent. So that $307,000 loan would result in monthly payments of $2,079 on a 15-year loan. This would mean that your monthly payments would increase by about $450 each month. That’s more than most people can swing.
It’s nice to have your loan paid off in half the time, but if you can’t swing that, stick with the 30-year loan. Ideally you would make those prepayments each month to help you pay off the loan more quickly. Of course, you would have the flexibility to pass a little if times are tight, but if you can continue to make those higher payments, you should try to continue doing that each month.
Okay, now you can contact your mortgage broker to see if you can save money.