Interest rates on mortgages are hovering near all-time lows. Lowering the interest rate on your mortgage to secure some of the best interest rates of our lifetimes seems like a good idea. However, refinancing a mortgage includes many factors that make it hard to figure out whether you should submit an application. In this article, we'll help you decide if you should refinance your home and share several reasons why you shouldn't.
What’s happening with mortgage rates right now
As the coronavirus pandemic began, the federal government took drastic steps to reduce interest rates to spur borrowing by consumers and businesses.
The Federal Reserve reduced the fed funds rate (the rate at which banks borrow) to nearly 0%. The fed funds rate directly influences interest rates on savings accounts, credit card interest rates, home equity lines of credit, and other variable rate debt. However, these interest rates don't directly affect mortgage rates and it does not mean you’ll get a mortgage with a 0% or even negative rate.
The Federal Reserve also began a massive bond-buying program of $700 billion to reduce interest rates on U.S. Treasuries and mortgages. Mortgage rates are loosely tied to the 10-year U.S. Treasury rate. By increasing the demand for Treasuries and mortgage bonds, that lowers the interest rate on Treasuries and mortgages.
Since these actions in March 2020, mortgage rates have fallen to 3% or even lower.
8 reasons you should refinance your home
With rates so low, refinancing your mortgage to get a better interest rate could sound very appealing to you. Here’s some reasons why refinancing might be a good idea that go beyond just your interest rate:
1. To reduce your interest rate
Reducing the interest rate on your mortgage is often the first reason people think of when it comes to refinancing your mortgage. A good rule of thumb is that if you can reduce your rate by .50% to 1% or more, a refinance is worth pursuing. You can investigate your options among the best mortgage lenders, but make sure the costs of refinancing don't eat up any savings on your interest rate.
2. To take advantage of your credit score going up
Your credit score changes on a regular basis. Reducing your credit card debt and making consistent on-time payments on your mortgage should help your credit score increase. If your credit score has improved since you took out your mortgage, you might be able to qualify for a lower rate or better terms through a refinance.
3. To lower your monthly payment
Reducing your monthly payment can be a relief for people whose budgets are stretched thin, especially when the future of your job is uncertain. When you refinance into a new 30-year mortgage, you are stretching out your payments over a new 30-year time frame. This can lead to a lower payment, but don’t forget it does extend the life of your loan.
4. To convert from a variable to a fixed rate
Low interest rates aren't guaranteed forever. This is why it can make sense to convert from a variable-interest rate mortgage into one with a fixed rate. Consolidating a HELOC into your mortgage can also be a good idea while rates are low. In both situations, you're locking in this low rate for the life of your mortgage without fear of the interest rate ever increasing.
5. To eliminate mortgage insurance
Many homeowners pay mortgage insurance because they didn't put down enough money when they bought their home. Although many homeowners can request to get rid of mortgage insurance once they have enough equity, those with Federal Housing Authority loans made within the past few years cannot.
If your FHA loan was made any time after January 2013, you cannot eliminate your FHA mortgage insurance premiums, no matter how much equity you have in your home. The only way to eliminate it is to refinance your home into a conventional mortgage.
6. To reduce your loan term
Many homeowners start out with a 30-year mortgage. As your income grows and other debt is paid off, you may have extra to pay down your mortgage quicker. One way to do this is to refinance into a shorter-term mortgage. For example, you might refinance from a 30-year mortgage into a 15- or 10-year mortgage, depending on how aggressive you want to be in paying off your home.
7. To pull cash out
With home prices on the rise, some homeowners are refinancing their homes to consolidate high-interest debt or to fund home improvements. Pulling cash out with a new mortgage ensures that the debt is at a lower rate than an unsecured loan and allows you to spread the payments out over a longer period of time.
8. To buy out your ex-spouse
If you're divorced but your spouse is still on the mortgage, refinancing is a smart way to remove your ex from the mortgage. Just keep in mind that your former spouse may still have to sign an acknowledgment during the refinance process.
8 reasons you should not refinance your home
Although refinancing your mortgage to lower your interest rate sounds like a good idea, it is not the right move for everybody. Below are some of the reasons you shouldn't refinance your mortgage right now:
1. Your refinance costs are too high
Refinancing a mortgage can be expensive. The costs include an appraisal, title insurance, broker's fees, and more. Make sure the costs don't eat into your savings too much. (We'll take a look at how to calculate the break-even period on your refinance in the next section.)
2. You lose protection from creditors
In some states, the mortgage to buy your home is considered non-recourse. This means the lender cannot sue you for the difference between the loan balance and the value of the property in case they foreclose on the home. When you refinance your home, you lose this protection.
3. You’re planning to move in a few years
Coronavirus has impacted moving plans for many people. If you are planning to move or pay off your mortgage in a few years, there might not be enough time for the interest rate savings to make up for the closing costs of the refinance. You may be better off just paying extra to reduce your mortgage balance.
4. Your credit score has dropped
Your credit score makes a big difference in the rates and programs available to you. If your score has dropped, now may not be the time to refinance. Focus on how to pay off your debt first so you can boost your score before proceeding.
5. You want the money for luxury purchases
Most experts agree that doing a cash-out refinance to splurge on luxury purchases or funding a vacation is a poor choice. You're paying a long-term debt for a short-term purchase.
6. Your existing mortgage has a prepayment penalty
Most mortgages today don't have prepayment penalties. However, if your mortgage is older, you may still have one and it can become an issue when you refinance. A refinance still may make sense even if you have to pay this penalty; you just need to include the cost of the prepayment penalty into your calculations.
7. You want to fund your investments
With the stock market near all-time highs, you may be interested in investing more money. But pulling money out of your home to invest in a volatile stock market can be very risky. Instead, consider refinancing your home to save money, then invest those savings every month into a robo-advisor or brokerage account.
8. Your income is not stable
Refinancing your home requires a stable paycheck. The lender will ask for paystubs and W-2s at the beginning of the financing process, and then they check with your employer one more time before the mortgage closes. If your job status is uncertain or your income varies widely, it may be difficult for you to get approved.
How to calculate the break-even period on your refinance
Even if there are costs associated with your mortgage refinance, it can still make sense to do it if you'll be in your home for several years. It all depends on what you determine to be the break-even period. The break-even period tells you how many months it will take to recoup your costs — and any savings you continue to make after that will be profit.
Here's how the Federal Reserve recommends you calculate your break-even period:
|Start with your current monthly mortgage payment||$2,199|
|Subtract your new monthly payment||- $2,073|
|The difference equals your monthly savings||$126|
|Subtract your marginal tax rate from 1 (e.g., if your marginal rate is 28%, then 1 - 0.28 = 0.72)||0.72|
|Multiply your monthly savings (No. 3) by your after-tax rate (No. 4)||126 x 0.72|
|This amount equals your monthly after-tax savings||$91|
|Total of your new loan's fees and closing costs||$2,500|
|Divide total costs by your monthly after-tax savings (from No. 6)||$2,500 / $91|
|The number you get is the number of months it will take you to recover your refinancing costs||27 months|
In this example, refinancing will be a good money move if you plan to be in the home for longer than 27 months from the point you refinance. If you are considering refinancing your mortgage, make sure you work through this math to see whether it will actually save you money.
Refinancing your home while interest rates are near all-time lows is appealing. You can lock in ultra-low interest rates and make progress toward your financial goals. But there are some reasons why refinancing might not be the right move, so think about this decision from all angles before proceeding.
If you determine a mortgage refinance makes sense for you, now is a great time to save money. Speak to your bank or loan broker to learn how to get a loan on your home.