August 25, 2022
You may have heard the traditional rule of thumb to only refinance if you can lock in an interest rate that’s at least a full point below your current rate. While guidelines are helpful, it’s not as black and white as it may seem. Let’s explore where that advice comes from and if there is ever a time to ignore it.
The full point rule and the costs of refinancing
You might wonder why this rule of thumb seems so important. Wouldn’t any interest rate reduction help you save? The reason lies in the costs of refinancing.
A refinance replaces your current loan with a new mortgage, and this comes with costs. Appraisal fees, title fees, attorney fees, and lender fees are almost always part of the process. Closing costs may get bundled together to be paid up front or rolled into the loan, your monthly payments. Either way, refinancing fees will affect your true savings.
There are ways to keep costs down, such as refinancing with a credit union or using a government-backed streamline rate reduction if you qualify.
Calculating your time to break even
A simple way to determine whether you’ll benefit from a refinance with less than a full rate drop is to use a mortgage calculator. You can compare monthly payments at different interest rates and then calculate the break-even point, taking into account closing costs.
Here’s an example of a $300,000 home with $50,000 in equity using 30-year fixed rates of 5.5%, 5%, and 4.5%.
|Interest Rate||Monthly Payment (Principal & Interest)||Monthly Savings||Closing Costs||Months to Break Even|
|5.5%||$1,420||$0 (current loan)||N/A||N/A|
In this case, it would take over three years to break even when the interest rate is half a point less than your current rate. A full point reduces that time to less than two years. If you don’t plan to sell your house in the next five years or so, it looks as if a half percentage point difference may still be favorable.
Taking your term into account
Now for the curveball: Even if you’re comfortable with your break-even point, you might still not come out ahead. Why? If your goal is to pay less interest over the life of the loan, and not simply save on monthly expenses, you need to take into account your term.
For example, if you’re five years into a 30-year mortgage and decide to refinance for another 30, it’ll take five extra years to pay off your loan. That’s 60 months of interest payments you wouldn’t have had otherwise, which could add up to tens of thousands of dollars.
It would be wise to reduce your mortgage term, even if that means increasing your monthly payment. This can be done by refinancing to a 15-year or even a 10-year fixed mortgage; or you could stay at 30 but vow to pay extra on the principal. That’s often easier said than done.
When to consider a refinance for less than a full point
Now it makes sense: That full point can often indicate whether a refi is worth it. But there are exceptions. Here are some examples of when you might consider refinancing at less than one interest-rate point.
- You calculated your time to break even and don’t plan to sell your home before you can reap the savings
- You’re refinancing into a shorter term and know you’ll pay less interest over the life of the loan
- You have an a (ARM) and are approaching the end of your fixed-rate period
- Your primary goal in refinancing is to access equity to fund home improvements, pay off higher-interest debt, or consolidate debt
A home mortgage is often the largest and longest payment a consumer will make in their lifetime. With so many factors in play, the decision to refinance is not something you need to make alone. Contact a trusted lender to help you through the process.
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