There are several good reasons to refinance your mortgage such as consolidating debt, getting cash out, extending your term for a lower monthly payment, but I think the rate/term refinance is my favorite. It often puts members in a better financial position both in the short-term and in the long-term. But, how low should a mortgage rate be to make refinancing a worthwhile decision? I have heard several different theories on what the interest rate savings needs to be for refinancing to be advantageous. Some say the magic number is a 0.5% rate reduction. I’ve also heard the rule of thumb is 1% off your current rate. However, I’ve even heard it must be at least 2%, as well.
With all these differing views, here are a few factors that I think are important for you to consider:
Your current mortgage balance
- The greater your remaining balance, the more you will benefit from refinancing and obtaining a lower mortgage rate.
The cost of refinancing
- Financial institutions often allow you to add in all of your closing costs into your new loan. However, closing costs do exist (even when you are only looking to pay off what you owe on your existing mortgage) and can be expensive. Closing costs will include a full appraisal, a new title examination, lender’s title insurance, processing fees, underwriting fees, and other necessary miscellaneous fees. These fees will increase your loan amount, which decrease your equity.
The remaining term on your loan
- As with the mortgage balance, the greater the term you have remaining on your loan, the more you will benefit from a lower interest rate.
Whether you have plans to sell your house or pay off the entire loan in the near future
- If the answer to this question is yes, you will need to calculate potential interest savings over the estimated time you plan to keep your loan, rather than the entire loan term. The longer you plan to stay in your home without paying off the loan, the more a rate/term refinance will benefit you.
As you can see, I do not believe there is a specific numeric rate reduction needed to refinance. Every situation is different. As long as you are not extending the term on your loan, the decision is really simple math. If you lower your interest rate, you will lower your monthly payment. This will create a savings over the course of the remaining loan term. With the current record low mortgage rates, your savings can be significant and in many cases, refinancing is a no-brainer. You can benefit from these savings in the form of a lower monthly payment or you could chose to keep a similar monthly payment and benefit from the savings in the form of a shorter term.
A great exercise to see what your potential interest savings may be is to research the current mortgage rates and use a mortgage calculator online to compare your current mortgage to what your new mortgage would be if you refinanced. Below, I’ve included a sample calculation to demonstrate this for you.
Example of Interest Savings Exercise:
Current loan balance: $150,000
Remaining term: 180 months (15 years)
Current rate: 5.375%
Current monthly payment: $1216.03
Current total payments amount: $218,884.88
VS.
Proposed loan balance with closing costs: $153,000
Proposed term: 180 months (15 years)
Proposed rate: 2.875%
Proposed monthly payment: $1047.58
Proposed total payment amount: $188,563.92
Current Total Payment Amount $218,884.88 – Proposed Total Payment Amount $188,563.92 = $30,320.96 Savings
In this case, is it worth it to add in the closing costs to your loan and go through the refinance process? As you can see, you could potentially save more than $30,000 over the next 15 years by refinancing. In my opinion, the answer to this question is yes. Because this exercise is an easy step in helping you consider refinancing, I would suggest taking a few minutes to plug in your numbers and check out your potential savings.
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