Is Now a Good Time to Refinance My Mortgage?
With mortgage rates at historical lows, I have received several questions about refinancing. My wife and I chose to refinance our mortgage this Spring, so I wanted to share our experience. We chose to refinance in order to reduce our interest rate and shorten our loan. The process proved to be relatively seamless, but the closing took place during a very chaotic time amidst the “stay at home order”. It also happened to be a couple of weeks after my wife gave birth to our second daughter.
The first obstacle I ran into was getting our cashier’s check for the closing. Our bank is one of the large national banks and although there is a branch only minutes from our house, it was temporarily closed due to coronavirus. That meant I needed to drive 30 minutes to the nearest open branch. When I arrived at the bank, I remembered that according to the new guidelines, I was not allowed in the building without a mask. The bank had a security guard at the door checking for masks as each person walked in. As I was looping the elastic straps around my ears, one side broke. I now had one strap around my ear, and another side flapping in front of my face. The security guard would not let me in without a mask and I did not have another one in the car, so I had to hold the flapping side of the mask against my face. When I entered the building, there were several people waiting to speak with a bank teller. Each person had a circle to stand on to maintain social distancing. After a 15-minute wait standing on my circle, it was my turn to speak with the bank teller. The teller was wearing a mask and was located behind a sneeze guard in which I had to pass my bank card and driver’s license under. Once I did, the teller asked me to “step back” six feet while she processed my request. When I returned to my circle, the teller asked, “How may I help you today?”
We both had masks on so we could not see each other’s mouth. I was standing six feet away from the counter and there was a sneeze guard between us. At this point, there were several other people standing on their circles throughout the bank and likely listening to our conversation whether they wanted to or not. I spoke loudly and said, “I need a cashier’s check”. She did not hear me the first time, so I spoke louder. She then asked, “What is the amount?” This time, I was a little dumbfounded as I did not feel comfortable discussing an amount which was several thousand dollars when standing so far away. Reluctantly, I yelled the amount for the check. Once the check was completed, she motioned for me to walk up. She slid it to me under the sneeze guard and asked me to move back to my circle. She then asked, “Would you like your checking and savings account balance?” I quickly said “No”, but I wanted to say, “Sure, and please provide my social security number too for anyone who is taking notes”. By this point, the entire bank knew enough about my financial situation, so I did not feel the need to share the remaining details with them. All joking aside, although the bank experience was extremely odd, the overall process went well, and we were able to close the following day.
After working with clients for many years, it has become apparent that homeowners consider refinancing for four main reasons: reducing the total interest paid, reducing the monthly payment, consolidating debt, and removing private mortgage insurance (PMI). A detailed description is provided below as well as the common pitfalls to be aware of.
Reasons to Refinance:
Lower the interest rate and reduce the total interest paid over the length of the mortgage
If interest rates have dropped since the mortgage was originated, refinancing could save the homeowner a significant amount of interest over the life of the loan.
Example of reducing the total interest paid:
If a homeowner currently has a 30-year, $300,000 mortgage at 4.25% and has the option to refinance into a 30-year mortgage at 3.25% they would save approximately $60,000 in interest payments over the life of the loan.
There are two scenarios which are important to keep in mind when trying to reduce the total interest paid.
When planning to move within the next few years, the closing costs of the refinance will likely offset any interest saved during this period and will eliminate the advantage of refinancing.
When refinancing into a longer mortgage, extending the payment length could result in more interest paid even if the interest rate is lower. In this case, it would make sense to refinance into a loan that matches or reduces the years left on the mortgage.
Example of refinancing into a longer mortgage:
If a homeowner has a 30-year, $300,000 mortgage at 4.25% with 20 years left on the loan and has the option to refinance into a 30-year mortgage at 3.25%, they would pay an extra $15,000 interest over the life of the loan.
For this individual, it will be more effective to refinance into a 15-year mortgage at a lower interest rate to truly reduce the interest paid over the life of the loan.
Lower the minimum monthly payment
Homeowners that are interested in reducing their monthly mortgage payments through the refinancing process can do so in a couple of ways.
The first scenario occurs when a homeowner receives a lower interest rate and can refinance into a shorter mortgage. This results in both a reduced monthly payment as well as reduced interest over the loan period.
Example of a lower monthly payment and lower interest rate:
A homeowner has a 30-year, $300,000 mortgage at 4.25% with 15 years left on the loan and has the option to refinance into a 15-year mortgage at 3.0%. By refinancing, the homeowner would reduce the monthly payment by $130 and reduce the amount of interest over the remaining 15 years by $22,000.
The second scenario occurs when a homeowner needs to lower their monthly mortgage payment due to limited cash flow. In this case, the homeowner will refinance into a longer mortgage. Even if the interest rates are lower, the refinance will likely result in additional interest being paid over the term of the loan.
To consolidate debt or pay off debt that is at higher rates
When a homeowner has consumer debt in addition to their mortgage, a refinance could provide an efficient way to consolidate debt and reduce overall interest due.
Example of consolidating debt through a mortgage refinance:
A homeowner has a $300,000, 30-year mortgage at 4.25% with 15 years left on the mortgage and has the option to refinance into a 15-year mortgage at 3.0%. In addition to the mortgage, the homeowner also has $20,000 in credit debt and is paying 15% interest on this debt. The refinance will give this individual the ability to consolidate all debt into the primary mortgage at 3% which greatly reduces the monthly interest owed on the credit card debt.
To eliminate private mortgage insurance (PMI)=
When a homeowner has a conventional mortgage in which the down payment was less than 20%, mortgage insurance (PMI) is added to the monthly payment until the loan to value ratio drops below 80%.
When a homeowner has a Federal Housing Administration (FHA) mortgage, the mortgage also includes PMI. In older FHA loans, the PMI is dropped once the loan to value ratio is below 80% like a conventional mortgage. In newer FHA mortgages, the mortgage insurance does not go away until the end of the loan. In these cases, the only option to eliminate PMI is to refinance into a conventional loan once the loan to value ratio is below 80%.
Now that we have discussed the most common reasons to refinance a mortgage, it is important to cover a few items to be aware of during the decision-making process.
Common Pitfalls of Refinancing:
Closing Costs
There are costs associated with the refinancing process which include application fees, title fees, and appraisal fees. It is important to consider these when determining the savings that will be achieved through refinancing.
In addition, do not fall for the “no-cost” refinance. These “no-cost” refinance options provide an increased interest rate over the term of the loan so the lender can recoup costs. However, there is still a cost associated to the homeowner. A refinance with reduced up-front costs can make sense for certain borrowers who do not have sufficient cash available to pay closing costs, but it is not accurate to label this a “no-cost” refinancing.
The Appraisal
In some cases, the appraisal can be waived by the lender which will save the borrower money on closing costs. Ask the lender about waiving it.
In cases where an appraisal is required, it can sometimes throw a wrench into the process. If the appraisal comes back lower than the anticipated amount, this can cause an issue for the borrower. The borrower may be forced to bring additional money to closing so that PMI is not required. In other cases where the borrower was hoping to consolidate debt, a lower appraisal will mean that they may not be able to consolidate all their consumer debt into the mortgage.
Locking the Rate
Upon starting the refinancing process, the lender typically provides the borrower with the current interest rates and length options. Once the borrower decides to move forward, the lender will ask if the borrower wants to lock-in the rate or let it float. If the borrower believes that interest rates could fall between the start of application and the closing date, letting the rate float could be a good idea but in most cases locking-in the rate is recommended as rates are already at historical lows.
Adjustable Rate Mortgages
When interest rates were higher, adjustable rate mortgages were more common. However, they are still offered today so it is important to be aware of them. Adjustable rate mortgages (ARM) typically have a 5- or 7-year time frame in which the mortgage rate is lower than conventional fixed mortgage rates. After the initial period, the interest rate adjusts to a market rate which is higher. Given the current low interest rate, an adjustable rate mortgage likely does not make sense.
With our current interest rate environment, now may be a good time to reach out to your lender to discuss your refinancing options. I am available if you need help sorting through the options that your lender provides. In addition, if you do not have a lender you trust, I am happy to provide a referral.
