When Sam purchased his first home, in 1987, he took out a 30-year fixed-rate mortgage with an interest rate of 12.75 percent. Any meaningful drop in the interest rates after he took out his loan meant he could refinance and save a bundle of money over the remaining years on his loan.
Over the past 10 years or so, interest rates have remained extraordinarily, almost historically, low. The 30-year fixed-rate mortgage rate average has fluctuated between about 5.6 percent in June 2009 and a low of about 3.3 percent in December 2012, according to the Federal Reserve Bank of St. Louis website. Today, the 30-year fixed-rate interest rate stands around 4.5 percent.
If you locked in a loan at 4 percent, and interest rates never fell below that level again, you might not be able to save money by refinancing. If interest rates ever fall below that point, it might be a financially smart move to refinance and obtain a lower interest rate for the loan.
We usually have advised our readers to make sure they understand what they are doing when it comes to refinancing a loan. Not all refinancing is worth it. If the interest rate is marginally lower and the costs to refinance are high, you could be worse off with a new loan than with the old one.
We’ll try to describe it rather simply. If you take out a $200,000 loan for 30 years at 4.5 percent, you’ll have a monthly payment of about $1,013. (Remember, this payment is only to pay back the principal and interest owed on the loan and does not include our real estate tax or insurance payments.)
If mortgage interest rates drop to 4 percent a year later and you refinance, your new 30-year mortgage payment would drop to about $954 but — and this is important — you’d have added a whole year of loan payments to your loan. Your old loan would have been paid off in full in 2049 and the new loan would be paid off in full in 2050.
To compare these loans apples to apples, you'd want to figure out what your payment would be if you paid off the new loan in 2049 so that both loans would terminate at the same time.
Using simple online amortization calculators, you can compute what you’d need to pay on your new loan to get it paid off in 29 years: about $972 per month. So the actual difference in the monthly payment in the old loan at $1,013 per month and the new one at $972 is a savings of about $41 per month.
Here’s the kicker: You need to know what it will cost you to refinance. Again, you need to remember to exclude tax and insurance escrows or other payments that you’d make no matter what. When the lender tells you that you’ll have to pay title company or settlement company fees of $2,000 along with recording or other government fees of $500, you’ll know that your closing costs solely because of refinancing will be about $2,500. Because you will save $41 per month on the new loan, it will take you a bit more than five years to break even on the refinance.
Spending $2,500 today and saving only $41 per month may not be worth it. Having said that, if you actually refinance and keep that same loan until 2049, you'll save a bit over $20,000 over the life of the loan.
Of course, we’ve made all kinds of assumptions, and the reality is that most Americans don’t stay in their home for 30 years. Every year, millions of Americans move. You’d want to balance the odds that you’ll stay in the home for a given length of time with the savings you’ll get from refinancing. The lower interest rates go and the lower the costs to refinance, the better you do in the short term and over the length of the loan.
If you’re not going to save money, why else might you refinance? To take cash equity out of your home.
Let’s say you purchased your home for $200,000 15 years ago, and now the home is worth $400,000. You may have children heading off to college, parents with medical issues, adult children that need assistance buying a home or myriad other situations that may require you to have cash on hand. In these situation, you may have paid down your original loan substantially and need to tap some of the equity.
You could get an equity line of credit or a second mortgage on your home. However, with interest rates as low as they are, you may want the security of fixing your interest rate for the loan term. So maybe you apply for a cash-out refinance with a 15-year loan term. Once you have those funds, you can pay off debt, pay off medical expenses, help your children with college or home-buying costs, or help your aging parents with any issues they may have.
For a home-run refinance, try to find a deal that helps you do these four things: lower your interest rate, shorten your loan term, lower your monthly payment and control your closing costs.
Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact them through her website, ThinkGlink.com.