Growing up, I thought refinancing a mortgage meant a couple wasn’t making it financially. Therefore, I put a negative connotation on the word refinancing. My only concept was that people were refinancing their mortgage to extend their loan and decrease their monthly payment and therefore, were paying more in interest over the long-haul. That to me was not a sound financial decision. Paying more for the same asset over a longer period of time makes no sense.
It wasn’t until I got to college and started studying personal finance that I learned refinancing could be a positive thing. It can save significant amounts of money for individuals. It does not save on the principal of the home, but on the interest paid to the lender. Saving on interest means real dollars that individuals are saving. Paying less for the same item is a great financial move!
Mortgage refinancing can be considered a tool that people can use to minimize interest expense. However, people need to know the facts to make sure refinancing is done for the right reason of minimizing interest.
Why to Consider Refinancing Now
Mortgage rates are at historical lows. Some institutions are advertising that mortgage rates are less than 3%. According to Freddie Mac, 30-year mortgage rates haven’t been below 3% in the past 47 years.
This means now could be a great time to refinance an existing home mortgage.
Personal Finance Rule of Thumb
If you’re not sure if refinancing your mortgage is right for you, know that in personal finance there is the rule of 1%. That is, if your current rate is 1% greater than the refinanced rate, now is likely a good time to refinance.
If your interest rate is 4.87% (the average mortgage rate in November 2018), but today you could refinance at 3.87% or lower, now is likely a good time to refinance per the rule of 1%.
But that’s not enough to ensure you are paying less for the same item. Here are 5 rules to follow during the refinancing process.
Five Rules to Ensuring Your Mortgage Refinancing is a Smart Financial Decision
There are five things to consider to ensure refinancing a home mortgage is a smart financial decision.
- Ensure you can obtain a loan that has an interest rate lower than your current mortgage rate. This is important because not all individuals get the lowest rates possible due to creditworthiness.
- Shop around. When looking to refinance, there is of course the interest rate to take into consideration, but also important are the points (pre-paid interest) required to obtain the interest rate and closing costs. By shopping around, individuals can ensure they are shortening the breakeven point and increasing savings related to their mortgage interest expense. Consider your current lender, but also consider new lenders. There are advantages/disadvantages to both, but looking at the numbers will help you have confidence you are making the right financial choice.
- Focus on refinancing the loan for the balance of the current mortgage on the property. Often when refinancing, lenders may offer the opportunity to take out a larger mortgage. This may seem appealing because then when the mortgage closes, you will receive a check to maybe remodel or something. However, you’re going to pay interest on that amount. You’ve likely already paid interest on that amount already (unless your home has appreciated). Taking out a larger mortgage balance now is like taking one step forward and two steps back.
- Only consider loan terms that are the same or decrease the length of the loan. For instance, if someone currently has a mortgage with 23 years left to pay on it, refinancing for 25 or 30 years increases the chance that the terms of the new loan won’t save money in the long run. Even though interest is amortized, meaning it decreases over time, that is still three to eight additional years on which interest is charged. So, in this instance considering a 15 or 20-year loan gives more opportunity to save interest expense.
- Only consider refinancing if the breakeven point will be met. When refinancing a mortgage, lenders will again charge closing costs and they may also require points to be paid (think of this as pre-paid interest). Take the closing costs divided by the monthly amount of interest savings. This is the breakeven point. If the breakeven point is 2 years; however, you plan to sell the property or have the original loan paid off in one year, it likely is not a good time to refinance. However, if the breakeven point is two years but there are no plans to sell the property or paying off the loan won’t be for 2 years and one month or greater, then refinancing would decrease your interest expense over time.
Our Recent Experience with Refinancing
The inspiration for writing this post hits close to home. We have refinanced our home during the pandemic to lower our interest rate. We could decrease our interest rate on our mortgage by greater than 1%, we shortened the length of or mortgage. We did the math and the break-even point for us is about 2 years. Referencing the 5 rules above.
One warning I want to give: Our lender gave us figures on what our refinanced mortgage would cost up-front. They gave us the mortgage rate, expected closing costs, and the points figure. We had shopped around and decided we were going to use our current lender. So, we watched rates, and when we decided it was a good time to “lock in our rate” we notified our contact person with the lender. That meant that we were agreeing to the terms of the refinanced loan.
In our opinion that meant the loan amount, length, closing costs (which were relatively fixed numbers since we were using our current lender), and points. What we noticed was that as the process progressed the lender increasingly used higher numbers for the amount of points we were going to be required to pay. Points are pre-paid interest that the lender charges for the interest rate they are offering. We noticed this and pointed it out several times to our contact person (in writing).
We were informed by that person many times that it would be corrected at closing. Closing came and the points were not updated to what we originally agreed to, and our main contact was out of the office – the one that we had discussed the issue with several times. See, it didn’t change our monthly payment much $5-$15, but over a 20-year loan that is as much as $3,600. That’s $3,600 in the lenders pocket and not in ours.
We forwarded our email communications showing that it would be fixed at closing and finally came to an agreement with the lender for a lenders credit that made up the difference. Bottom line is to thoroughly review the documents, not pay more than you agree to, and make sure communications are in writing.
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