Almost everyone expected interest rates to rise when S&P downgraded US long-term debt. In a predictably irrational market response, long-term interest rates fell. While this downward trend may eventually reverse itself, now would be a great time to dig out all your mortgage loan paperwork and consider refinancing.
Start with finding out what your current interest rate is on your mortgage loans. Let’s assume you currently have a mortgage with a balance of $200,000, with principal and interest (P&I) payments of $1264 at an interest rate of 6.5%.
Next, do a little shopping. Call two or three mortgage brokers and find out the interest rate you could obtain on a new loan. You will need to give them your household income, the value of your house, and the current balance on your mortgage. If you don’t know the current value of your home, call your county Director of Equalization and find out its assessed value.
Ask the broker to give you the interest rate and payments on a mortgage that is almost equal to the number of years you have left to pay on your loan. Also find out what the interest rate and payments are on a shorter-term loan than your current mortgage, maybe comparing 15-year and 30-year mortgages. Usually, a shorter term has a lower interest rate.
Next, get the broker’s estimate of your closing costs. These are the expenses you will need to pay to close the loan, such as title insurance, the cost of an appraisal, closing fee, points, and other various fees. Lenders sometimes charge points, also known as origination fees, which are included in your closing costs. One point equals one percent of the loan’s value. Mortgages described as “no-cost” or “zero points” do not carry this cost, but the interest rate may be higher, thus increasing the long-term cost of the mortgage.
Now you are ready to analyze whether getting a new loan makes financial sense. Let’s assume you find out you can obtain a new loan with a similar term at 5%, with monthly payments of $1,074 and closing costs of $1,900. The new payment is $190 less than your current $1264. Dividing the closing cost by the monthly savings ($1,900 / $190 = 10) gives you the number of months—ten—you need to keep the house in order to “break even.”
If you intend to sell your home in the next few months, it may not be advisable to refinance. I also typically advise against refinancing if the months to break-even are much over 24. Few of us know what curves life may toss us, and looking two years ahead is my comfort level. If your break-even point is 24 months or more, either wait for interest rates to fall further or shop for a loan with lower closing costs.
When shopping for a new mortgage, you may be tempted to reduce your payment even more by lengthening the term of your new loan. While the benefit is more short-term spending money, the downside is many more years of having a house payment. You will also pay more in both points and interest rate. My strong suggestion is to obtain a new mortgage that is equal to or less than the number of years you have left to pay on your current mortgage.
Remember that a lower interest rate doesn’t automatically mean refinancing is in your best interest. The amount of money you save monthly, the amount of your closing costs, and how long you plan to live in your home are key variables that influence whether you should refinance your mortgage.