If we look at the average mortgage rates over the past five decades, we can see that today's rates align with those historical averages. And yet, after enjoying mortgage rates under 3% in 2021, rates in the 6%-7% range are a tough pill to swallow. Those buying a home today have been hit with a double whammy — higher interest rates and higher home prices. For many of us, there's comfort in the idea of refinancing our mortgages when the rates drop. But how do we know when the time is right?
What is refinancing?
In a nutshell, refinancing your mortgage means trading in your current mortgage for a new one. You apply for refinancing through a mortgage lender, and if approved, the lender uses the new mortgage to pay off the original loan.
Homeowners have all kinds of reasons for refinancing their mortgages, with the most popular being to land a lower interest rate.
What a lower rate can do for you
Let's say you have $240,000 left to pay on a 30-year mortgage at an interest rate of 7%. Your principal and interest payments would run $1,596 per month. If you were to refinance the mortgage with another 30-year mortgage at 5%, your principal and interest payment would drop to $1,289. Just as importantly, the total interest you would pay over the life of the loan would drop from $334,590 to $224,024.
You might even want to take it further by refinancing the original mortgage with a new 15-year loan instead. Lenders typically offer a lower interest rate on 15-year notes, so let's say you snag a rate of 4.5%. Your monthly payment would increase from $1,596 to $1,836 per month, but rather than pay $334,590 in interest, you'll pay just $90,477, and your loan will be paid off in half the time.
In this scenario, simply refinancing the loan at a lower interest rate will leave you with anywhere from $110,500 to $244,000 extra. That's money you may want to put toward other debt, your child's education, or to build your retirement fund.
How do you know when the time is right?
Opinions vary. Some say you should consider refinancing when rates drop by 1%, while others insist rates need to drop by 2% or more. Only you can determine when refinancing is worth it for you and your budget.
Just as you paid closing costs when you took out the original mortgage, you can expect to pay closing costs when you refinance. When a lender advertises “no closing costs refinancing,” it typically means you don't have to pull out a check or credit card to pay the costs upfront. Instead, the lender will roll closing costs into the loan balance. If you'd rather not spend years paying interest on the closing costs, you can pay them upfront.
Depending on the lender, closing costs will run between 2% and 6% of the amount you're borrowing. For example, if you're borrowing $240,000, closing costs could be anywhere from $4,800 to $14,400. As you can see, that's a wide range. As you shop around for a low refinance rate, it's equally important to shop for a lender with low closing costs.
To illustrate, let's use the same scenario we used above. You have a 30-year mortgage at a rate of 7% and owe a balance of $240,000. As the interest rates begin to cool, you find a lender willing to refinance at 5% with a total of 3% in closing costs ($7,200).
If you take out another 30-year mortgage, your payment drops from $1,596 to $1,289, for a monthly savings of $307. With an extra $307 monthly, you could pay yourself back for the $7,200 paid in closing costs in just under 24 months. But remember, snagging a lower rate means you'll pay $110,500 less in interest than you would have if you'd stuck with the original mortgage. Even if you subtract the closing costs from $110,500, you still end up $103,300 ahead.
Know what you're looking for
Those who've purchased a home since interest rates began to climb must determine how low they need the rate to drop before they pull the ripcord and refinance. At what point is refinancing worth it?
One way to come up with an acceptable APR is to use a mortgage calculator to run different scenarios. For example, if your current rate is 7%, refigure your monthly payment and the total amount of interest paid over the life of the loan by plugging in lower interest rates. Then, determine the highest rate at which you would be comfortable refinancing.
It's important to remember that it could be many years before interest rates drop to your “dream rate,” so decide what would be an acceptable number. That's when it's time to check rates daily and follow trends. Once the rate hits your target, it's time to begin shopping for a new mortgage.
You'd be hard-pressed to find anyone who thinks applying for a mortgage (or refinancing) is fun. But once you've gone through the hassle, the savings can be fairly spectacular.
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