With interest rates at an all-time low, this is one question that all homeowners with a mortgage are asking themselves. While there are many variables to consider first before you can determine if you should refinance, one thing is certain: you should absolutely take the time to investigate whether this is a good decision for you. It’s never been so cheap to borrow money, and your mortgage is such a large loan, that the potential savings over the life of your mortgage are tremendous.
People think about refinancing for a variety of reasons—to lower their interest rate, to tap their home equity for cash, to eliminate mortgage insurance, or to improve other terms of their mortgage such as reducing the term, or switching from a variable rate to a fixed rate. Not all of these reasons are equally prudent, so let’s take a look at a few different types of refinances that all center around lowering your rate and see when it makes sense to refinance and when it doesn’t.
Lower the Rate and Receive Cash at Closing
The “cash-out refinance” is easily the most tempting type of refinance for homeowners. Mortgage rates have dropped? Perfect, you say, now you have a ready-made “responsible” reason (lowering your rate) for refinancing your mortgage to do what you really want to do (access your home equity). With a little bit of business on the front end and some party on the back end, it’s the mullet of refinancing. And c’mon, was a mullet ever a good idea?
Most of the time, the motivation for a cash-out refi is to tap your home equity for the purpose of some major expense. This is rarely wise. You should be very wary about using debt to fund large purchases. Borrowing against your home may feel different than putting something on a credit card, but it’s really not that different. It’s just another flavor of buying stuff you can't afford.
Despite the jokes, doing a cash-out refi is less black and white than I’ve made it out to be. There are instances in which tapping your home equity—especially now, with rates this low—could be a savvy move. Consolidating certain types of higher-interest rate debt, using it for necessary repairs or cash in an emergency are a few examples.
Conclusion: DON’T DO IT (exceptions apply)
Lower the Rate Only
In a “rate reduction refinance”, the main improvement you’re getting is the lower interest rate on your refinanced mortgage. With interest rates being so low, this is likely the type of refinance that most homeowners are considering, The rule of thumb that most of us are familiar with is the 1% rule—if you can improve your rate by 1%, it’s a good idea to refinance. If you can’t, it’s not. That rule is certainly helpful, but it’s worth further investigation, as there are other factors which could be at play.
For example, if you’ve already paid off a decent portion of the principal on your original mortgage, think carefully about refinancing to a new 30-year note, even if you are getting a better rate. It may still increase your interest costs over the life of the loan since mortgage payments are front-loaded. A greater portion of your payment goes to interest in the early years.
On the other hand, also consider your home equity. If you had less than 20% equity when you first took out your mortgage, your lender likely requires you to pay property mortgage insurance. If the equity in your home is now over 20% AND you can get a lower rate, refinancing would provide the double benefit of eliminating your mortgage insurance and lowering your interest costs.
This type of refinance has the most shades of grey in determining if it’s a prudent financial decision. See the final section about breakeven period, which will loom large in your analysis.
Lower the Rate and Reduce the Term
This type of refinance is often called a “rate and term refinance” or a “no cash-out refinance”. There are two main improvements: you get a lower interest rate, and you change the payoff schedule so that your home will be paid off more quickly. Both of these changes result in meaningful interest savings over the life of the mortgage, making this a great refinance.
All other things being equal, reducing the term of your mortgage will increase your monthly payment, which is the main hurdle to this type of refinance. However, if the interest rate improvement is large enough, you may be able to keep your monthly payment somewhat equal or even lower it. But even if your monthly payment does increase a bit, the interest savings from the lower rate and reduced term make this worth it.
This type of refinance is the least satisfying from a “benefits now” perspective, but it’s the best way to maximize today’s low-rate environment for your long-term financial health.
Conclusion: DO IT
No matter which type of refinance you’re considering, crucial to your analysis is calculating your breakeven period. Your breakeven period is the number of months it will take for the savings you’re receiving to overcome the closing costs of the refinance. Be sure that when you’re calculating your “monthly savings” you’re not simply comparing your new payment to your old payment, but comparing the interest portion of your new payment, to the interest portion of your old payment.
Once you know your breakeven period, ask yourself if you confidently expect that you’ll stay in your house through that length of time. Even a refinance with great terms isn’t worth it if it’s likely that you’ll sell your house before that breakeven period is up.
It may not be a slam dunk that you should refinance your house, even if you can get a better rate. But it’s absolutely worth your time to do the analysis to see if it’s worth it or not. And while there are many reasons to refinance, we think some are much better than others. The best type, in our opinion, won’t bear fruit immediately, but will put you on a path with an accelerated pace to financial freedom.