Time to Refinance Your Mortgage?

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Amazingly, mortgage rates are once again at historical low levels. Last year the average rate on a 30-year mortgage was 4.54 percent. Now rates have dropped below 4 percent. A few mortgage providers are even offering 3.75 percent! If you’re a homeowner with a higher rate, should you refinance?

Whenever mortgage rates drop, it’s always prudent to consider refinancing. However, the value of refinancing a mortgage differs with each homeowner’s situation. To make the correct decision, you need to consider closing costs, the interest rate differential, and how long you plan to remain in your home. So, when is it appropriate to trade in your rate for the lower rate, and when is it better to stay the course?

Closing Costs

Closing costs are the various fees and charges involved with processing the refinance loan. These costs include the origination fee (typically 1 percent of the loan amount) for the lending company, paperwork fees for the title company, and recording fees for the local government office. In addition, there’s the cost of title insurance and appraisals.

Regulations requiring lenders to be more accurate in their good faith estimates of total closing costs have helped lower these fees. According to Bankrate.com, the average closing costs are around 2 percent; however, that can vary significantly.

So how do you determine whether refinancing is worth the cost?  Start with the amount you would save each month from your lower interest rate and then calculate how long it will take you to recoup the closing costs. For example, if your potential savings with the new rate is $125 per month and your closing costs are $3,000, it will take you 24 months to offset the refinance costs.

Legitimate programs that offer very low closing costs are available.  So don’t be afraid to shop around.  Many lenders offer no-closing cost refinances, but you will generally pay a higher interest rate. This may make sense if you don’t intend to stay in the home long term or if you have limited cash to pay the closing costs out of pocket.

Staying or Moving?

The second variable in your refinancing decision is the length of time you plan to remain in your current home. Do you have plans to start a family and anticipate needing more bedrooms?  Or, are your kids nearly off to college and you’d like to downsize sometime in the next three years.

If you don’t plan to stay in your home for at least as long as it would take to recoup the closing costs, you’re wasting your money!  As we saw in the example above, to justify paying the closing costs to refinance your loan, you would need to remain in your home at least two more years. Any less time would mean you lose money.

Likewise, if you plan to stay in the home long term, opting for a higher interest rate to obtain a no-closing cost mortgage can also be expensive!

Hazard:  Refinancing with Longer Term

Extending your refinanced mortgage beyond the remaining term of your original loan can cost you more in the long run.  For example, if you have had your 30-year mortgage for ten years, you have twenty years left to pay on the loan.  If you refinance your remaining mortgage balance for more than twenty years, you may pay more interest than if you had maintained your original loan. 

Let’s assume your original 30-year mortgage of $200,000 has an interest rate of 5%. Your monthly payment is $1,069. Over the life of the 30-year loan, you would pay $184,908 in interest.  After ten years, your loan balance is $162,000 and you decide to refinance at a rate of 3.5%. If the new loan has a period of twenty years, your payment is $937, a reduction of $132 per month. You would pay total interest over the combined 30-year period $153,145. This is a savings in total interest of nearly $32,000.

However, if you refinanced at 3.5% interest over a new 30-year period, your monthly payment would be much lower at $725, but the total interest paid over the combined forty years of the two loans would be $189,433. This is actually $4,500 more than the total interest you would have paid over the original 30-year mortgage.  You paid more interest and it took forty years to be mortgage free.

Moral of this example:  Don’t let the mortgage lender convince you to refinance for a longer period than your remaining mortgage. If you do, refinancing only reduces your monthly payment, not the overall cost of your home mortgage.

Summary

Refinancing can be very beneficial, but you need to consider more than the reduction in your monthly payment.  While it is always tempting to secure a lower interest rate, do the calculations to be sure it’s the smart move for you.

Ryan Collier is the Director of Investment Management for Bedel Financial Consulting, Inc., a wealth management firm located in Indianapolis. For more information, visit their website or email Ryan.

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