When is an Interest Rate Reduction Worth Refinancing?
Is it worth refinancing for a 1%, .5%, or .25% interest rate reduction? This article will help you make the best decision.
If you pay any attention to the real estate market or the mortgage industry, you’ve inevitably heard that interest rates are low. Even if you simply pay attention to the news, you’ve likely heard about “historically” low rates and mortgages approaching 2% or lower in total interest.
These low interest rates, rightfully so, are one of the main reasons that 2021 is expected to be a great time to purchase a home. With today’s low rates, aspiring homeowners can finance the purchase a property at a much lower total cost. The market appears to be responding to these low rates and has maintained strong performance even through the COVID-19 pandemic.
But it’s not just new buyers who are taking advantage of low rates. Low interest rates have also motivated many current homeowners into refinancing their homes. With the ability to reduce their interest, and hence their total payments, many homeowners are jumping at the chance to refinance.
Should you join this trend?
To make a choice in refinancing, one of the most important aspects (but certainly not the only consideration) is how much you can reduce your interest rate. When you know how much the interest rate is reduced, you can calculate your monthly savings. These savings should then be compared against the total cost of refinancing.
At What Interest Rate is it Worth Refinancing?
There are, to be certain, dozens of variables to consider when refinancing. Variables that impact your decision include:
- Your current interest rate
- Your potential new interest rate
- The remaining mortgage balance
- The current payment total
- The potential payment total
- The remaining number of payments
- The terms of a new mortgage (30-year or 20-year, for example)
- The cost of refinancing
With so many variables, it would be virtually impossible to run through every possible scenario to find an exact percentage reduction where refinancing is the right choice for every mortgage. But we’ll do our best to give you a general understanding of this issue.
What’s the Cost of Refinancing?
Refinancing is not free. For most refinancing services, the cost is about 2% to 5% of the total cost of the loan. So if your remaining balance is, say $300,000, you can expect to pay roughly $6,000 to $15,000 to refinance the loan.
Even so-called “no-closing-cost” refinancing options have terms that essentially work the cost into the new loan. You may not be paying for the costs up front, but you may have the cost rolled into your mortgage balance, or you may simply pay a higher interest rate.
Anything Above 1%? Seriously Consider Refinancing
If you are able to refinance and gain more than a percentage point in reduced interest, it almost always makes sense to take this option. The exact savings will vary, but unless you have a very short timeframe on the loan, you will likely save in the long run by refinancing, even if you pay higher-than-normal closing fees.
Refinancing to a 1% Reduction
If you are refinancing a loan and reducing the interest by 1%, you are likely to gain a financial advantage. 1% is the generally-accepted rate that refinancing becomes useful to homeowners. Suppose you have a remaining balance of $300,000 on a loan that has 15 more years remaining, and you are able to reduce your interest from 4% to 3%.
At 4% interest, you would be paying roughly $1,818 in principle and interest payments. But if you could reduce it to 3%, assuming all other factors remain the same you would have a monthly payment of $1,664, a monthly savings of roughly $154 a month. (This is a simplified example, so the savings won’t be exact.)
If we assume you make the remaining 240 payments over a 20 year period, this would mean a total savings of $36,960! Even if we take out, say, $6,000 for closing costs, we are left with a savings of over $30,000. This makes refinancing practically a no-brainer!
Even if you have a shorter period left on the loan, refinancing to a 1% reduction could be worth the costs, time, and effort.
But when you reduce it below a single percentage point, is it still worth the savings?
Refinancing to a .5% Reduction
There are really only a few scenarios where refinancing to a .5% reduction would be worth it. You have to have a long time remaining on the loan, have a large balance, and not pay too much in closing costs.
Suppose we look at the same scenario as above, but instead we move from 4% to 3.5%. In this case, the new payment is $1,740 for a monthly savings of $78. This translates into a savings of $18,720, minus the closing costs. So it’s still worth it, but this example assumes a long time frame on the loan. If you only have ten or even five years remaining, the savings will be less and may not make up for the closing costs.
Refinancing to a .25% Reduction
At .25%, you are far less likely to see an advantage from refinancing. But that doesn’t mean it’s impossible to benefit. If you have a large balance, can get a good deal on your refinance, and have a long time remaining on your loan, it may be worth the effort.
Just look at our example above. If we go from 4% to 3.75%, the payment drops to $1,779, a savings of $9,360. Not bad, but if you take out the cost of refinancing, you may only save about $3,000. Over the 20-year life of the loan, it may not be worth it.
The Longer You Have Left on the Loan, The More Refinancing Makes Sense
Generally speaking, the longer you have left on your loan, the more it makes sense to refinance even at a smaller interest rate reduction. So if you have 25 years left on your loan, it could make financial sense to refinance to a rate that is only 0.25% lower.
However, if you only have five years left on the loan, a quarter-of-a-percentage reduction won’t safe much, and, when refinancing fees are considered, will likely cost more that it’s worth.
Get Reliable Expert Refinancing Advice
If you want more information on refinancing, or if you need help crunching the numbers in your mortgage, contact our helpful staff today. We’ll provide honest advice so you can make the right choice for your future!