March 3rd, 2020 12:22 PM by Jackie A. Graves, President
With 30-year fixed mortgage rates currently averaging around
3.50%, it might make sense for homeowners to consider refinancing. Depending on
several factors, such as your current interest rate and age of your existing
mortgage, refinancing could mean a lower monthly payment and big savings over
the life of the loan.
will the Federal Reserve’s decision to cut rates impact mortgage rates?
The Federal Reserve has just cut interest rates by .50% in
response to growing concerns about the economic impact of the coronavirus. What
does that mean for mortgage rates?
The Federal Reserve does not set mortgage rates or any interest
rate for that matter. The Federal Funds rate is a suggestion of
what banks should charge each other to borrow money overnight so banks can meet
their reserve requirements. It is the shortest of short-term rates. As
evidenced in the chart above, the Federal Funds rate doesn’t move in lockstep
with mortgage rates, particularly 30-year fixed mortgages.
Variable rate mortgages are more likely to move lower in
response to today’s announcement as loans are shorter, typically over five or
seven years, and typically pegged to the prime rate.
Mortgage rates are influenced by many different factors
including demand from homebuyers and homeowners for new loans, current economic
conditions, inflation, and demand from investors to buy mortgage loan debt.
Demand for loans generally increases when rates are low, as cheap financing
pushes more buyers to opt for a mortgage
instead of paying cash and existing homeowners are eager to refinance.
Mortgages simultaneously serve two different clienteles:
borrowers taking out a loan and investors buying that debt. Borrowers want low
rates and investors require a return that will compensate them for the risks of
holding the debt (e.g. default, prepayment, etc.). The required return will
change relative to yields on other fixed income investments, the broad-based
economy, and future expectations.
The best way to check current mortgage rates is to speak with a
lender to discuss your financial situation and the property. Data on mortgage
rates is available (at a lag) from Freddie Mac and Mortgage News Daily also publishes
rates daily based on a survey.
Interest rates are very low right now, so unless you bought or
refinanced in 2012 or 2013, odds are your rate is higher than what you could
get today, assuming no changes to your credit or income that might negatively
impact your profile as a borrower. When you refinance a mortgage, you get a new
loan and use the proceeds to pay off your existing mortgage. The principal is
typically your current outstanding mortgage balance and the loan will be
re-amortized over a new period, perhaps 30 years.
Refinancing your mortgage can be a great way to increase your
monthly cash flow and pay less in interest over the lifetime of the loan. But
before rushing off to speak with a lender, it’s helpful to understand how the
potential benefits and drawbacks of refinancing can change relative to your
When you first start payments on a fixed-rate mortgage, most of
your monthly payment is interest expense, with a much smaller amount going to
pay down your principal. As the years pass, more of your fixed monthly payment
will drift towards paying down the loan principal.
Since so much of your monthly payment is interest expense at the
beginning, refinancing a mortgage obtained more recently can provide greater
savings to homeowners over the life of the loan (all else equal) compared to
individuals who have had their loan for longer, as they’ve already gone through
the years with the greatest interest expense and did so at the higher rate.
Although homeowners with a newer mortgage may see greater
overall savings, individuals with an older mortgage will generally see the most
significant drop in their monthly payment. As explained above, when you
refinance, you’re getting a new loan. When homeowners refinance a longstanding
mortgage, the new loan amount will be reflective of the principal they’ve paid
to date. Combined with a lower interest rate, the savings can be substantial.
By way of example, consider two homeowners who both purchased a
home with a $500,000 loan and 4.25% interest rate. Both are now considering
refinancing at 3.25%. The first owner purchased in 2010 and the second buyer
obtained a loan in 2018. All else equal, the first homeowner will have a
smaller monthly payment after refinancing.
As you might imagine, your potential benefit from refinancing
depends, in part, on how much your new interest rate will change relative to
your current one. The bigger the spread the bigger the potential savings. If
you’re considering refinancing, a starting point for your cost-benefit analysis
should be the payback period for your closing costs.
Lenders estimate that closing costs are generally between .75%
and 1% of the loan. Although you can arrange for a zero-cost refinancing by
paying a higher interest rate or rolling it into the principal, it will cost
you more over the life of the loan. Further, the additional debt isn’t
tax-deductible as it exceeds the existing loan balance. To calculate how long
it will take to recoup your closing costs, divide the expected closing costs by
the monthly savings from refinancing.
Using the example above and assuming closing costs are 1% of the
loan, the payback period for homeowner one is a little more than five months,
meaning they would break even on the cost of refinancing very quickly. In other
situations, it can take years to break even on the closing costs, so you’ll need
to consider how long you plan to own the home before deciding to refinance.
Also note that if your home is in a living trust, you will likely
need to take the home out of trust to refinance.
Analyzing the cumulative benefits of refinancing a mortgage is a
fairly complex exercise. In addition to the considerations raised above, the following
factors also come into play:
What will you do with extra
cash each month? One component of the
benefit analysis is what you decide to do with the extra cash in your pocket
each month. Paying down other high-cost debt or investing for financial goals
can increase the benefits of refinancing, but if the money is just spent on
lifestyle expenses, your upside will be limited.
Will refinancing impact
your taxes? In 2020, the standard
deduction is $24,800 for married couples and half that for single filers. Given
that state and local taxes are limited to $10,000 per return, mortgage interest
is usually the extra push that allows taxpayers to itemize their taxes so
they can benefit from charitable deductions and other
deductions only available to itemizers. Consult your CPA to discuss how
refinancing could impact your tax situation.
Tax law changes: Under the 2017 tax reform, when homeowners refinance, the
allowable interest will only be deductible for the remaining term of the debt
that was refinanced. Previously, the interest would have been deductible for
the full term of the new mortgage. Also, refinanced loans greater than $750,000
(but less than $1M) that were issued before 12/15/17 can keep their
‘grandfathered’ status for the mortgage interest deduction, provided the
refinance does not increase the principal. While refinancing to a new loan with
the same term as an existing mortgage won’t necessarily extend a mortgage
interest deduction in perpetuity, it can offer investors greater flexibility to
maintain a low monthly payment with the option—but not the obligation—to pay down the mortgage
more aggressively each month.
Now may be a great time to refinance your mortgage and enjoy the
flexibility of lower monthly payments. Although refinancing may seem like a
hassle, depending on your current situation, it could (literally) end up paying
off for years to come.
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