A frequent news alert people see these days is: “Mortgage rates drop to record lows”. And seeing an opportunity to save money, a lot of people end up clicking to see if they can benefit from that.
But news articles are written to keep you updated about what’s going on. What they rarely offer is an insight into whether the drop in rates would yield tangible benefits to you.
Some people decide to refinance without understanding the true benefits. And some refrain from doing anything only because they don’t understand the implications very clearly.
So let’s try to understand whether it makes sense for you. So when you see such a news item next time, you’ll hopefully make a more informed decision.
When should you think about refinancing?
Mortgage rates and one’s own financial and personal situation change all the time. If you belong to one of the following categories, you have a good reason to be looking into a refinance.
- Mortgage rates have dropped and your current rate is higher than prevailing rates
- You have other debts (credit card, education loan, auto loan etc) where the rate of interest is higher than the rate at which you can refinance your home.
- You have a private mortgage insurance because your loan amount is high (i.e. more than the typical 80% of home value)
- If your financial situation has changed and you can afford larger payments to pay off your loan sooner.
- If your credit score has improved significantly since you got your mortgage, it might save you a lot by refinancing.
How much will you save?
People read about drop in rates and the first question that comes to mind is how much will I save every month. There are plenty of mortgage calculators on the internet to help you with that. Read about how to use mortgage calculators.
– Type your loan amount, mortgage term and the current rate. See your monthly payment
– Now do the same again, but with your new rate.
– The difference in payments is your savings every month.
Let’s see this with an example
Say, you have a 30Y mortgage with a loan amount of $300,000 and the rate on your mortgage is 3.5%. Your monthly principal and interest (P&I) payment will be $1347. See: Annual Percentage Rate Disclosure
Now let’s say, with a refinance, you can get a rate of 3.0%. Your monthly P&I payment will go down to $1265.
That amounts to savings of $82 a month or approximate $1000 a year. That’s a reduction of almost 6% on your monthly payment.
How do you ascertain if that’s savings enough? The idea of breakeven
When you get a mortgage, there are closing costs associated with it – From appraisal to title insurance and from origination fee to escrow. According to Zillow, you pay anywhere between 2 to 5% in closing costs.
In the above example, say your closing cost is equal to 2% of loan amount. That means you’ll pay close to $6,000 in closing costs.
Since you pay $6,000 in closing costs and save $1,000 a year, it’ll take almost 6 years for you to break even.
How so? Well, you pay $6,000 today to get the new mortgage, which you wouldn’t have to pay otherwise. Now if you save $1000 a year as a result, it’ll take you 6 years to break even on the closing costs.