Real Estate Matters: A rate reduction or lower monthly payment alone may not be a sufficient reason to refinance
Q: We took out a mortgage in 2011. It’s a 30-year loan with an interest rate of 5.125%. Our expected payoff date is 2041, but we’ve been paying biweekly. We expect to pay it off in 2035.
At this point, we would like to refinance. This is what we have on the table: a 20-year loan with an interest rate of 3.25%, which will lower our payment by $331. If we pay this loan off biweekly, we will pay it off in 2037. We also have an offer for a 15-year loan at 2.75%, but our payment would go up by $50. We can handle the increase, but if we pay this loan biweekly, we will pay it off in 2033.
Both the 20-year loan and 15-year loan offer significant interest savings. Closing costs will be rolled into the loan. Which would be the best option for us?
A: Well, it seems to us that you have made it a priority to live mortgage free. Which is a terrific choice for many homeowners, even at today’s historic low interest rates.
Given your preferences to pay down your mortgage as fast as you can, we suggest you move forward with the 15-year loan. With the 15-year loan, you’ll be mortgage free by 2035, or perhaps even a few years earlier if you continue to make an extra payment per year. With your current loan, you’ll be mortgage free no later than 2041. And on your current path, you will save at least six years of interest payments.
We generally think a home run refinancing is when you can lower your monthly payments (excluding real estate taxes and homeowner’s insurance), lower your overall interest rate, reduce the time it will take to pay off the mortgage, and start enjoying the benefit of the reduced savings within six to nine months of the loan closing.
A rate reduction alone may not be sufficient for us to recommend that you refinance your loan. Frequently, the loan closing fees can be greater than the savings you’d achieve with a loan refinancing and in that case, the rate reduction is not enough.
A lower monthly payment alone is also insufficient to justify refinancing a loan. Let’s say you’re 10 years into your 30-year loan. If you refinance now in order to be able to lower your monthly payments, but add another 10 years to your loan, those additional 10 years may cause you to pay much more than the savings you are getting from the monthly payments. (And yet, if you’re going through a cash crunch, lowering your payments might be enough of a reason to refinance.)
Finally, if you find a refinance opportunity that gives you a lower interest rate, lower monthly payments, and you can pay off the loan on or before the time your original loan payoff date would occur you might be golden.
The one exception has to do with loan closing fees. Those expenses can mount quickly, which is why it’s important to watch how much you’re getting charged. Without making it too complicated, if your loan closing fees are $1,000 and your monthly payment goes down by $100, it will take 10 months until your “savings” equals the out of pocket costs for the refinance. If, however, that your loan closing costs are $6,000, it will take you five years to end up even. We’d rather see you recoup any out-of-pocket closing costs within the first year after a refinance.