Personal Finance Friday - When to Refinance
It's that time again... Interest rates have begun to drop and a question in your head, if you own a home or investment property is, "Is it time to refinance?"
This is such a tricky question because there is no "right" answer because you don't know what interest rates will do tomorrow, and you don't know how your life circumstances will change. That being said, you can increase the probability of making a good decision by thinking through a few things.
First, are you going to pay less interest? I know this seems obvious but it's kind of the first step. Take a look at your mortgage statement, what are you paying? Now go to Bankrate.com and look at their mortgage refinance rates, are they less? If they are less then we can move on to step two! There other reasons to refinance like to pull cash out, but unless you're super disciplined with money, I'd be VERY careful with that!
Second, how much are you going to save? Take your mortgage and multiply it by your current interest rate, okay that's what you are paying now in interest each year. Now take your mortgage again and multiply it by the rates you're seeing on bank rate... now subtract the two numbers. What is it? Let's run through an example: you have a $200,000 mortgage at 5% currently. So you pay $10,000 a year in interest. You see that the lower rates on Bank Rate are 4%, so with a new mortgage you'd only be paying $8,000 a year in interest. You will save $2000 a year! Sadly thought it is NOT that simple...
Third, how much is this all going to cost you? Refinancing isn't free. They may try to trick you and say it's free, but either they mean you don't have to put any cash up front, or they are hiding all the fees in a higher interest rate. When you are looking at Bankrate there are two numbers to look at, the rate and the APR. The APR is a way of trying to incorporate all the extra charges into your rate. If the numbers are close together then the explicit fees (the fees they show you and aren't hidden in the interest rate) are relatively low. So the trick is understanding what is a good rate by comparing to a bunch of companies and also picking one with a low difference between the rate and APR. But from lots of experience I can say you are probably going to end up paying 1 to 2% of your mortgage value in fees. So in our example that's about $4000 of costs, either hidden or explicit. So that means it's going to take you at least 2 years to break even, $2000 of savings each year and $4000 of cost up front.
Fourth, are you saving enough to make the decision worth it? This is truly the hardest part, because it contains all the unknowns. For example, will you be in your home for at least two more years? If not then DON'T do the refinance, if you are pretty sure you are staying, then that's a point for possibly doing it. Will interest rates go even lower and so should you wait? Well that one literally nobody knows, seriously it has been proven that nobody can reliably predict which way interest rates will go, so I'd say don't assume it will get any better. In our example, a payback period of just two years is pretty good, but it gets dicier when it looks like it might take 4 or 5 years, it might be worth waiting and looking for a better deal in that case.
So that's a summary of the steps you should be thinking about. I'd also add that when you refinance you extend the term of the loan, think about that. In an ideal situation, you are paying off your loan just before you retire to help reduce expenses. A good idea might be to think about any savings you get from the refinance, and put it back into the principle and pretend like the payment hasn't changed.
Right now it looks like rates are near the all time lows of 3.5% So if your paying more than 4.0% you might want to take a look at your options.