Wall Street is going crazy, and investors are bailing out over coronavirus. With the 10-year Treasury slipping below 1 percent, homeowners have a once-in-a-lifetime opportunity to refinance their mortgages. Mortgage rates are near record lows, which could potentially save homeowners who refinance thousands of dollars a year in interest.
Indeed, a multitude of homeowners did just that: Applications for refinancing last week soared 79 percent.
How can you be sure if refinancing is the right decision for you? Here are three questions to consider before filling out the mortgage refinancing application:
How long do you plan to be in your home?
If you’re going to refinance, you should plan to stay in your home long enough to reach the break-even point, which is the point that the refinance actually starts to save you money. Often, people think that because the payment is lower, they save money right away, but, typically, there are upfront costs to refinance the loan, and it takes time to recoup those costs.
Many people have a misunderstanding of what the break-even point is and calculate it as the upfront costs divided by the monthly savings. On average, it takes 12 to 15 months to recoup the upfront costs. However, this does not take into account the balance on the original loan.
When you refinance a loan, you start the loan all over again, and the majority of your payments go toward interest. If you’re five years into paying off the original loan, you’ll revert to paying more interest and may fall behind on paying down the principal balance.
As an example, let’s consider the break-even point on a 30-year fixed rate, assuming a 3 percent cost to refinance. Most closing costs fall between 2 to 5 percent. If you can decrease your rate by one percentage point, you are looking at a little over three years until you reach the break-even point. If you decrease your rate by three-quarters of a percentage point, it’s closer to 4½ years, and if you decrease your rate by half a percentage point, it will be eight years before you break even. At one-quarter percentage, there is not a break-even point, and it is probably not in your best interest to refinance.
What is the age of your current loan?
If you have been paying off your current loan for a long time, you are probably paying down a lot of the principal already. If you refinance the loan, you have to take into consideration that it may take you longer to pay off the new loan. So even though you will reach the break-even point, there may be a second break-even point later on where you actually start losing money because the loan extends.
For example, if you refinance and reach the first break-even point five years after starting the new loan, you may hit a second break-even point 13 years in where you start losing money because you’re paying over a longer period of time. In this case, if you plan to be in the home longer than 13 years, it may not make sense to refinance.
There are plenty of online tools to help you determine if refinancing makes sense given your unique situation. One of my favorite calculators is the free Nerd Wallet Refinancing calculator, which allows you to enter your information to see how much refinancing could save you.
What will you do with the monthly savings?
To reach your break-even point earlier, you can use the money saved from the refinance toward loan payments. If you continue paying the same amount that you did before the refinance, that additional amount will go toward the principal value of the loan. This is a good practice if you are planning to stay in the home for a long time and if you’re looking to pay down the loan as fast as possible and pay the least amount of interest.
Another option is to pay down high-interest credit cards or other personal debt. This is an excellent strategy if you have debt with an interest rate more than 10 percent. If you put the savings toward high-interest debt, you essentially make yourself 10 percent or more by paying down the loan.
The savings can also go toward investments or other savings, such as a Health Savings Account (HSA) or 529 college savings plan. If you invest the money, set up investments on an automatic basis to regularly contribute to a mutual fund or retirement plan. You’ll earn money on top of the savings, which will help decrease your break-even point further.
Matt Anderson is a director and financial planner with the Wise Investor Group at Baird in Reston, Va.