Mortgage rates have dropped, but how do you know when it’s time to refinance?
SMITH BRAIN TRUST – With mortgage rates recently falling to a three-year low, maybe you’ve been wondering whether it might be time to refinance.
Maryland Smith’s Clifford Rossi has some math to help you decide.
“There are quite a few variables to consider,” says Rossi, Executive-in-Residence and Professor of the Practice at the University of Maryland’s Robert H. Smith School of Business. For example, what do the homeowners hope to gain from the refinance? Are they looking to pull out equity for a child’s university tuition or for a renovation project, or are they simply looking to save money?
The question borrowers should ask themselves, Rossi says, is when are conditions in your favor to refinance, or in finance-speak, when are you “in-the-money” to refinance?
For Rossi’s back-of-the-envelope calculations, he decided to simplify the motivation factor, and consider the refinance question strictly from the point of view of homeowners who are looking to save money.
First, Rossi says, homeowners should calculate the difference between their current note rate, compared to the prevailing market rate. “The bigger the difference, the more ‘in-the-money’ you are, and the bigger monthly savings you are likely to see.”
Just a fraction of a percentage point can make a sizable difference. Rossi ran some numbers to illustrate his point.
The average rate on a 30-year-fixed rate mortgage, the most popular home loan in the United States, was at 3.45%, as of Feb. 6, according to the Freddie Mac Primary Mortgage Market Survey data. That’s down from 3.72% in early January, a savings of about 27 basis points. A year ago, the average 30-year fixed rate was about 4.37% – or 92 basis points higher.
Let’s assume the homeowners have $250,000 remaining on their mortgage, and they locked in at that 3.72% rate, with a 30-year amortizing mortgage, and now they can drop their rate to 3.45% with a new 30-year loan.
Those homeowners would currently be paying a monthly principal and interest of about $1,155, and under the refinanced mortgage would have a monthly payment of $1,115. It’s not a big savings, Rossi notes, about $40 a month, but it’s only a 27 basis point reduction in the mortgage rate.
“Now, if you were paying 4.72% on your mortgage, and you were able to drop 100 basis points by refinancing, you would save about $185,” he says.
But your monthly outlay is only part of the story, Rossi notes. Before becoming a full-time professor at Maryland Smith, Rossi was Managing Director and Chief Risk Officer for Citigroup’s Consumer Lending Group, overseeing the risk of a global portfolio of mortgage, home equity, student loans and auto loans valued in excess of $300 billion.
Borrowers need to consider what points, fees and other costs they might incur by refinancing.
Let’s say that on the hypothetical mortgage, those points and fees together came to about $1,000 on the $250,000 loan amount. In other words, let’s imagine our homeowners are refinancing to a 3.45% 30-year mortgage, from that 3.72% rate.
“They’re saving about $40 a month, but it will take them about 25 months to break even on that $1,000 in loan fees and points,” Rossi says.
Homeowners should ask themselves how long they plan to stay in the house, he says. “If you’ve been in the house for a few years and you plan to stay in the house for the long haul, then, gee, that seems like the way to go. Any time you can reduce that payment and it’s not going to take you a long payback period to do it, that seems like a reasonable thing to do.”
On the other hand, if you’re thinking about relocating in the next couple of years for a bigger house, better school district or new job opportunity, it may not make that much sense to refinance.
Paying it off faster
If you’re thinking about refinancing, and if you have the means to do so, consider moving into a shorter amortizing loan, Rossi says, like a 15-year loan, rather than a 30-year. “This depends a lot on the borrowers’ circumstances,” he says.
In the hypothetical, $250,000 example, the homeowners would see their mortgage bill increase to about $1,700 a month, from $1,155. That’s the downside. “But they could pay off the house a lot faster,” Rossi says.
“Shop for the best rate that’s out there,” he says, when asked for his best advice for homeowners. Check sites like Bankrate.com for “a sanity check” on what rates are out there.
Know your credit score before you start shopping for a mortgage. Rossi recommends checking their scores at a site such as CreditKarma.com. “People always need to be mindful of what their creditworthiness is,” he says, noting that FICO recently changed its scoring methods.
Keep tabs on the overall economy, markets and the Federal Reserve. This year, median forecasts call for GDP growth around 2%, continued low unemployment and mild inflation. The stock market, Rossi says, appears poised for a pullback. “It’s too exuberant, even for my taste,” he says. “Most major asset classes out there are a bit rich.”
Diversify. “You don’t want to do anything stupid by putting too many eggs in one basket,” Rossi says. “But if you're already in a mortgage and you’ve got a good job, you can't hurt yourself by refinancing. Particularly if you’re planning on staying in the house for a while. Take advantage of the low rates while you can, put it in your pocket and let the rest of it happen.”
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