Rates Have Fallen, Is it Time to Refinance?

Cameron Hamilton

Interest rates have been falling since November and mortgage rates have followed suit.  Just like 10-year T-notes, both 30-year and 15-year fixed rate mortgages have seen rates decline roughly 1.1% over the last seven months (see the chart below).  Have rates hit the bottom?  They’re certainly close to historic lows.  Since the Federal Reserve began tracking 30-year mortgages in 1971, the lowest rate was 3.31% in November 2012.  Today that rate is 3.82%.  With this rate decline in mind, let’s explore when it is and is not a good time to refinance your mortgage.

Are rates low enough to justify refinancing based on the rate alone?  For most of the people we work with, the answer is most likely no.  Although the rate decline in the first chart above is intriguing, the second chart below shows that rates have been in the same ballpark since early in this recovery.  The yellow shaded portion of this chart highlights times when mortgage rates were more than 2% higher than today, a common rule of thumb to consider refinancing. You need to have a mortgage at least ten years old to take advantage of this spread.  While we work with many people who have enjoyed the same home for a decade, most of them have been approached by bankers to refinance by now!

And how did this “2% rule” for refinancing even come into existence?  By my research, it is not from some famous research paper in a finance journal.  Instead, it seems more like the infamous 3-months’ salary for an engagement ring rule: a “rule” manufactured by the sales organization for marketing and sales purposes.  There are simply too many variables for a hard-and-fast rule.  When it comes to evaluating mortgages, you must perform a break-even analysis: is the savings on interest enough to outweigh the cost of refinancing?

Let’s consider the two extremes to put the 2% rule to bed.  Two families own $600,000 homes and have a chance to refinance for $3,000, lowering their interest rates from 5% to 3%.

 

Remaining Payments 30 330
Interest Savings $2,417 $214,832

 

The family with only 30 months left on their loan should stay the course.  The family only 30 months into their loan should be beating down their banker’s door! In fact, that family should be happy to refinance for as little as 0.2% interest savings; they would still come out roughly $19,000 ahead.

Mathematically, loans with higher balances and longer remaining terms are more ripe to refinance.  If your loan was closed during a transient peak in interest rates, such as those highlighted in green in the chart above, it makes sense to perform a break-even calculation.  Even after seeing this math on lifetime interest, there are two traps and one opportunity to consider as part of your final decision.

Trap #1: Extending the Mortgage Period By default, loan originators want to refinance you into a new 30 or 15-year mortgage that can be resold to another institution.  If you are five years into your 30-year loan, they’ll point out that you can lower your payment AND total interest paid over the life of your loan.  But they omit the fact that you are now paying mortgage payments five years longer.  Go down this path every few years and you’ll never be mortgage-free, something we encourage everyone to shoot for in retirement.

Quick Fix: Add principal to keep your total payment the same.  Set it up automatically and you’ll pay off your home ahead of schedule and save thousands on interest.

Trap #2: Assuming this Home is Forever We can all appreciate the memories we’ve made in our homes, but when it comes to the mortgages, skip the unconditional love in favor of cold calculus.  Even if the interest savings is ample, it takes time to recoup the fixed costs of refinancing.  If your employment or family situation will have you considering a move in the next few years, you may not have time to recoup your refinancing costs.  We can calculate the exact break-even period for you.

Quick Fix: Save the eternal devotion for your family.  Don’t refinance if you may move soon.

One Opportunity: If you have an Adjustable Rate Mortgage (ARM), it is always a good time to evaluate switching to a fixed rate.  Unless you are an aggressive risk-taker, you likely have the ARM because of a temporary residence for school or work.  Keep an eye on your medium-term career path and if you think you may stay, consider refinancing.  Just be sure to refer back to Trap #2!

 

Source:

  1. Federal Reserve Bank of St. Louis; Federal Reserve Economic Data (FRED); 30-Year Fixed Rate Mortgage Average in the United States; Accessed June 7, 2019; https://fred.stlouisfed.org/series/MORTGAGE30US; Original Annotations by Author
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