December 1st, 2016 7:47 AM by Jackie A. Graves
Mortgage rates are on the rise.
As reported by the New York Times, rates
jumped 50 basis points virtually overnight. My own tracking of rates confirms
the jump, as reflected here.
And this raises an important question–when should you refinance a mortgage?
The common reason to refinance a mortgage is because rates have
gone down. This in turn raises the question of just how much lower rates must
be to justify the refi. We’ll answer this question below, and look at three other
good reasons to consider a mortgage refinance.
Rates Have Gone Down
The primary reason many homeowners refinance their mortgage
is to lower their interest rate. It’s why we refinance just about any loan,
whether it’s a mortgage, student loan,
or even credit card debt (think 0% balance transfer
cards). According to the White House, the average homeowner could save
$3,000 a year by refinancing their mortgage.
As you evaluate whether lower rates justify refinancing, consider
While rates have ticked up, predicting future interest rates is a
fool’s errand. Most predict that rates will rise over the coming months and
years, and I agree with this assessment. I also thought the Indians would win
the World Series. The point is that you should evaluate whether to refinance a
mortgage based on today’s rates, not a prediction of future rates.
How much you’ll save each month is a function of more than the
interest rate. Mortgage brokers often tout the lower monthly payment, but keep
in mind that the lower payment is also a function of the term of the new loan.
If you have 20 years left on your mortgage and refinance back to a 30-year
mortgage, the extended term will lower your monthly payment even at the same
It’s important to factor in the tax consequences of a refinance.
Lowering your interest rate saves money, but perhaps not as much as you may
think once you adjust the lower interest payments for the smaller tax
And that brings us to the question of just how much lower must
rates be to justify refinancing. There are numerous “rules of thumb” that range
from 0.50% to as high as 2%. A better approach is to do the math. It takes just
a few steps:
Determine how much in interest you’ll save each month (this number
goes down as you pay down your mortgage, but as a rough estimate for a long
term mortgage the first month’s savings can be used);
Reduce the interest savings by your marginal tax rate to adjust
for the smaller tax deduction (this only applies if you itemize your tax
Determine the total cost of refinancing your mortgage (your bank
or mortgage broker can provide this information); and
Divide the total cost of the refinance by your monthly after-tax
The result is the number of months it will take you to reach the
breakeven point. If you plan to stay in the home longer than the breakeven
point, refinancing makes sense. Here it’s important to focus not just on the
interest rate, but also on the cost of refinancing.
For example, I spoke with
the folks at Rocket
Mortgage about refinancing costs. Here’s what they told me:
”QL [Quicken Loans] origination cost is typically $1,049, that is the
only flat charge that is consistent. Everything else would be based off of
Fannie and Freddie pricing adjustments surrounding the areas such as credit,
Loan-to-Value, and debt-to-income (as DTI can dictate which programs you may qualify
If you didn’t follow all
of that, you’re not alone. The mortgage business is complicated. The key is to
get firm cost estimates from multiple mortgage lenders before making a decision.
Credit Score Has Gone Up
Even if rates haven’t gone down, you still may be able to qualify
for a lower rate if your credit score has improved. According
to myFICO, current mortgage rates can vary by as much as 1.50% based
on your credit score. On a $300,000 mortgage, a 1.50% higher mortgage rate due
to a mediocre credit score will add more than $250 a month to your mortgage
To qualify for the best mortgage rates, aim for a FICO score of
760 or higher. If you don’t know your score, there are several ways to get
your score for free.
To Lower Your Monthly Payment
In extreme cases, you may need to refinance your mortgage to lower
your payments, even if you can’t reduce your interest rate. By refinancing your
mortgage to a term that is longer than what’s left on the mortgage, you can
reduce your monthly payments.
For example, after paying on a $300,000 30-year fixed rate
mortgage for ten years at an interest rate of 4.00%, the outstanding balance
will be about $235,000 (according to my favorite mortgage calculator). The principal
and interest payments on this mortgage come in at about $1,430. By refinancing
the outstanding balance of $235,000 back to a 30-year fixed rate mortgage, the
payments drop to about $1,120 even at the same interest rate.
There’s no magic here. You’ve simply added back another ten years
of payments to your mortgage at the same interest rate. It’s not advisable
because you end up paying a lot more in interest due to the additional decade
of payments. But it does lower your monthly payment which may be helpful in
Convert An ARM To A Fixed Rate Mortgage
Finally, refinancing can make sense as a way to convert an
Adjustable Rate Mortgage (ARM) to a fixed rate mortgage. This is particularly
true if you believe interest rates may be on the rise. In the personal finance Facebook group I run, a member recently asked about
this very issue involving a 7/1 ARM at 3%.
He’s faced with a tough decision. Does he stick with a 7/1 ARM at
3% until the interest rate adjusts at the end of year seven? Or does he
refinance now and lock in a good rate by historical standards that is a bit
higher than three percent? What makes this decision so difficult is that
there’s no way to know what interest rates will look like when the ARM’s rate
In these circumstances I’m a big believer in a bird in the hand is
worth two in the bush. It’s certainly possible that rates could be lower
several years from now then they are today. But given historical trends, it’s
unlikely. Regardless, the current
30-year fixed rate hovers between 4% and 4.5%. And that’s after a
sharp and quick rise of 50 basis points, as reflected in this chart from Freddie Mac:
For me, I wouldn’t bet on rates staying low. If I financed a
property with an ARM, I’d be looking to refinance fast.
Rob Berger founded Doughroller.net, a personal finance website, allcards.com,
a credit card and banking website, and Dough Roller Money Tips, a free weekly
By Rob Berger
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