With interest rates near record lows, now must be a good time to refinance your mortgage, right? For many people, this is a great time to refinance, but in some circumstances, it might not be a good idea. There are many factors to consider when thinking about refinancing, so keep reading for the full breakdown.
There are numerous different overlapping reasons that you as a homeowner might benefit from refinancing.
To reduce your interest rate. – Mortgage rates today are almost the cheapest they have been at any time in American history. The average 30-year fixed-rate mortgage stood at 3.13% at the start of April 2021, and while this is a slight increase from the low of 2.65% recorded on January 6, it is actually lower than at any other time before the coronavirus hit in early 2020. In fact, mortgage rates never went below 5% until the global financial crisis in 2007-09 and double-digit rates were fairly common in the 1970s, ‘80s and early ‘90s. Therefore, if you’ve had a mortgage for more than two years, you have a strong chance of obtaining a lower rate today.
To shorten your repayment term. – People’s financial circumstances change as they get older – usually, but not always, for the better. A 30-year repayment term might have been the safe option when you first took out a mortgage, but perhaps you can now afford to pay off your mortgage in 10 or 15 years. Refinancing gives you the opportunity to shorten your repayment term – trading off higher monthly payments for the opportunity to pay less in total interest payments over the life of your new loan.
To switch between a fixed-rate and adjustable-rate mortgage. – If you chose an adjustable-rate mortgage (ARM) for your initial mortgage, it turns out that was a good move because falling rates have saved you money. However, with mortgage interest rates now near-record lows, it’s highly unlikely rates can fall any farther – but there is a lot of room for rates to move up. Therefore, if you’re on an ARM, switching to a fixed rate now allows you to lock in current low rates for the entire life of your loan.
To cash out your home’s appreciation. – The average sales price of houses sold in the United States has risen 44% since the end of 2011 and 71% since the end of 2002, according to the Federal Reserve Bank of St. Louis. A cash-out refinance is when the new mortgage is greater in value than what you owe on the old loan, allowing you to cash out the difference. A cash-out refi can be used for any purpose such as paying off debt, paying tuition fees, making home improvements, or putting money away for a rainy day. Home appreciation gives you greater equity in your home, giving you more leverage when it comes to using your equity to obtain cash.
Traditionally, the general rule has been that refinancing makes sense if you can reduce your interest rate by at least 2%. However, it is possible to save money when reducing your rate by as little as 0.75-1%. Because a refinance is essentially like taking out a new mortgage, it always involves refinancing costs – which can amount to anywhere between 2% to 6% of the new loan amount. Therefore, a small reduction in interest rate, e.g., 0.5%, usually isn’t worthwhile.
To figure out whether refinancing is right for you, approach a few lenders and see how the overall numbers (e.g., APR, monthly payments and total interest payments ) compare to the numbers on your current mortgage. Getting pre-qualified for a refinance won’t affect your credit but getting pre-approval or final approval will – which is why you should do a few basic calculations before going shopping for a refi.
Here are a few important things to consider.
The spread between your interest rate and current rates. – As mentioned above, there needs to be a decent gap between current mortgage interest rates and the interest rate on your existing mortgage for a refinance to make sense. If the average rate today is 2-3% lower than what you obtained when you took out your mortgage, then it probably makes sense to refinance. However, if the gap is just 1%, then it depends on a number of factors including the time remaining on your mortgage and the closing costs of refinancing.
The time remaining on your old mortgage. – As a general rule, the more time left on your current mortgage, the greater the potential to save by refinancing. If you only have five years left to pay off your current loan, then the closing costs associated with refinancing may be too high for a refinance to be worthwhile. Also, the minimum repayment term for a mortgage is usually eight to 15 years, so refinancing a mortgage near its end may mean unnecessarily dragging out your loan and adding to your total interest payments. However, if you’re only five years into a 30-year mortgage, there’s a good chance that even a small reduction in interest rate could save you money.
Your future intentions for your home. – How long you plan to live in your house should also be a factor in your decision. If you’re planning to move in a few years, then the closing costs associated with a refinance may outweigh any potential savings. However, if you’re planning to stay in your house for a long time, then refinancing probably makes sense.
Your current credit and financial profile. – One other important factor to remember is that your interest rate depends on your credit score and financial profile. Interest rates are near record lows, but if your credit score is worse today than it was when you took a mortgage, then the interest rates you qualify for may be higher than your current rate. However, if your credit profile has improved, then you should be able to tap into lower rates and save money.
Thanks to record-low interest rates, millions of Americans now have the potential to reduce their monthly payments and save money by refinancing. However, refinancing doesn’t make sense for everyone. Before applying for a refinance, think carefully about your existing mortgage and your own financial situation.