When is the Right time to Refinance Your Mortgage?

November 30, 2016

With mortgage interest rates being at record lows, how can you know when it is the right time to refinance your mortgage? There are actually certain methods that you can use to help you make a decision. The considerations are not always obvious, and that’s why you may want to use two or three of these methods before making a final decision.

When You Want to Convert from an ARM to a Fixed Rate

Since an adjustable-rate mortgage (ARM) represents a variable rate loan, it usually makes abundant sense to convert that loan into a fixed rate mortgage. Even if the current rate on the ARM is lower than current fixed rates, you will be trading an uncertain loan arrangement for one that is absolutely certain.

For example, say you are currently paying 2.75% on an ARM, but you could refinance into a fixed rate mortgage at 3.5%. In the short run, your monthly payment will be higher with a fixed rate. But ARM loans are subject to rate caps. Typical rate caps might be “2/6” – which means that your rate cannot increase by more than 2% in any single year or 6% over the life of the loan.

That kind of rate cap structure means that your rate on the ARM can go from 2.75% to as high as 4.75% in any one year. But if rates rise substantially over the next three years, it could increase to as high as 8.75%, if your initial loan rate was also 2.75%.

You would benefit from a refinance into a fixed rate mortgage because your rate would never exceed 3.5%.

When You Can Get at Least a 1% Reduction in Your Interest Rate

This hasn’t happened in a long time, but a rate reduction of at least a full percentage point will usually work out to be worth doing a refinance. For example, if you have a $200,000 mortgage, and you can reduce the rate by 1% per year, you will save $2,000 per year.

Now you may think that it might make sense to do a refinance if you can lower the rate by even less than 1%. After all, even a reduction of 0.25% will save $500 per year. But refinancing your mortgage will require you to pay closing costs that will generally run you several thousand dollars up front. That will offset the benefit of an incremental decrease in your interest rate.

A fractional reduction in the interest rate will only make sense if you’re doing a no closing cost refinance. But since such a refinance will be the result of a slightly higher interest rate, it usually cancels itself out.

Calculating the Break-Even Point

This is probably the most accurate way to determine if a refinance is worth doing. Every refinance will cost money to accomplish. This is due primarily to closing costs, such as attorney fees, title search, title insurance, appraisal fees, state and local mortgage taxes/stamps and other fees. You have to measure the “recapture” period on these expenses to know if the refinance makes sense. The break-even point will show you that.

It works like this: You get a good faith estimate from the lender, which spells out all of the closing costs connected with the transaction. You then divide the closing costs by the amount of money that you will be saving each month as a result of the refinance. In doing so, you will be determining the number of months that it will take for you to recapture the closing costs you’ve paid for the refinance.

Generally speaking, you should look to recover the closing costs paid in 24-36 months. The reason for that length of time is that you will want to recapture the closing costs as quickly as possible so that you will begin enjoying the benefits of the refinance for the greatest amount of time possible. Still another reason is that the longer it takes to recoup the closing costs, the greater the possibility that you will sell the home and move without ever benefitting from the refinance. You may be able to predict that over 2-3 years, but it will be hard to determine beyond that.

Let’s work an example. You’re looking to do a refinance that will save you $100 per month for the life of the loan. But it will cost you $3,000 in closing costs to do the refinance. To know if it makes sense, you divide the closing costs by the amount of the monthly savings to determine how many months it will take to break even on the loan.

The calculation will look like this:

$3,000 closing costs divided by $100 per month in savings = 30 months
30 months falls right in the middle of the 24-30 month range, so the refinance makes sense. The closing costs will be recovered in 2.5 years, after which you will save $100 per month for as long as the new mortgage is outstanding.

When You Want to Consolidate a First and Second Mortgage

A refinance can make sense if you currently have a first and second mortgage in which the blended interest rate on the two loans can be seriously reduced by doing a refinance. Say for example that you can do a refinance of both loans into a fixed rate mortgage 3.5%, and you have a current first mortgage at 3.75%, and a second mortgage at 6.25%. The refinance will enable you to consolidate the two loans into a single new first mortgage with a lower rate.

This can make even more sense if the second mortgage is a home equity line of credit (HELOC) that carries the variable rate. For example, if the rate on the HELOC is currently 4.5%, but has the potential to go up to 8.75%, a consolidation mortgage can make abundant sense. This is especially true if the HELOC represents a large percentage of the indebtedness that you have in your home.

If you have been sitting on the fence as to whether or not you should refinance, crunch the numbers based on the methods above, and see what you come up with. And always remember that it isn’t always about the interest rate. Just as often, it can make sense to refinance if you are replacing an ARM or other variable interest rate type loan with a fixed rate mortgage.

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