Updated: May 29, 2020
“The Fed” recently dropped rates to bolster the economy, and is talking about doing it again in the near future, so you might be wondering… should I refinance my mortgage?
While saving money on interest from a reduced rate may seem appealing, there are several factors to consider before starting the application. In this article, I’ll give you some insight into those factors and help you determine if a mortgage refinance is a wise financial decision.
The Federal Funds Rate And How It Affects Mortgages
Essentially, the federal funds rate is a short-term interest rate set by the Federal Reserve that banks charge other banks to borrow money from their reserve balance.
Banks are in the business of lending money, so when this short-term interest rate changes it also changes the rate banks can charge consumers for loans.
Think of it this way: If you were in the business of selling apples, and apples cost you $1.00 each, you could add 25% and sell them for $1.25 each, making $0.25 an apple in profit. If the cost of apples went down to $0.75 each, you could lower your prices to be more competitive and sell them for $1.00 while still making $0.25 an apple. This would be good for business because you’d sell more apples!
The same thing happens in the mortgage business. Banks often do not have enough money from customer deposits to lend as much as they’d like, so they borrow money from other banks at the federal funds rate, add their profit margin, and lend it to customers. When the rate goes down, they all race to reduce their mortgage rates in hopes that they’ll sell more mortgages.
This affects the stock market because the federal funds rate affects all types of loans. And when money is cheap to borrow, people and businesses borrow/spend more, helping to grow the economy!
The Real Difference 1% Makes On A Mortgage
Let’s say you have a $200k, 30 year mortgage, at 4.5% APR. You’ve been paying on it for 5 years and then rates come down. When you walk into the bank, they say “On your mortgage, after 30 years, you’ll have paid $164,813 in interest. Whereas at 3.5%, you’ll only pay $118,029. So refinancing will save you $46,784!”
While that statement is true, the fact of the matter is the average length of residency in the US is only about 10 years. So the vast majority of Americans never actually pay the full term of their mortgage… they just sell their house mid-term, pay off their current mortgage, and finance another one. So then, realistically we should only consider the interest paid in the first 10 years of the mortgage.
The Math (Buckle Up!)
At 4.5%, over 10 years, you’ll pay $81,783 in interest and be left with a balance of $160,179.
But let’s say that in year 5, you decide to refinance at 3.5%. You’d have already paid $43,118 in interest, leaving a remaining balance of $182,316 to refinance. Mortgage originators typically charge 5% of the loan value as closing costs, so that’d bring your amount financed to $191,432. For the next 5 years, at 3.5%, you’d pay an additional $31,854 in interest ($74,972 total) leaving you with a balance of $171,709.
So, you’d pay less in interest… but actually be worse-off financially! How is that possible???
Three reasons: additional closing costs, the term resets, and mortgage interest in front-loaded.
You see, when you refinance, you are paying the loan originator again (that’s why they want you to refinance). In this case, you’re paying them $9,116! They just add it to the loan so you don’t notice it. On top of that, the term resets. So instead of having 25 years left, you now have 30 years again. That’s bad because the interest on mortgages is front-loaded, meaning you pay more interest per payment in the beginning than at the end (see graph).
All of this adds up to you having less equity when you go to sell, which is what really matters.
Factors To Consider
Obviously, this is just one example and many variables are involved. For example;
How long do you intend to live in the property? The longer you live there after refinancing, the more the reduced interest cost offsets the additional closing costs and extended term.
What closing cost percentage will you be charged? In this example, we used the average 5%, but you may be able to refinance for less.
How much less will your interest rate be? In this example, the reduction was only 1%, but in your case it may be greater.
Something else you may be considering is a cash-out refinance, but that changes things considerably and should only be done under the supervision of a financial planner.
We are all trying to save money by paying as little interest and taxes as possible. Refinancing your mortgage (or any loan, really) can be a great way to reduce the amount of interest paid and thus keep more money in your pocket. However, I hope this article has impressed upon you that there is often more to a financial decision than meets the eye. Having a financial professional on your side to help you make a wiser financial decision can save you a lot of money and will ultimately assist you in reaching financial success.