When to Refinance Your Mortgage

Mortgage rates continue to be at record lows — as of this writing, the average interest rate on a 30-year fixed home mortgage is 4.26% — so many homeowners are probably thinking about refinancing their home mortgages. Is it worth it? Sure, you’ll see an immediate savings on your monthly mortgage payment, but you have to take into consideration closing costs, which can be another $5,000 to $10,000, depending on the associated fees assessed by your mortgage lender.

When we purchased our home in summer 2009, we were thrilled to get a 30-year fixed rate mortgage with a locked-in interest rate of 5%, which was a then-historic low. Now that rates are closer to 4.25%, we could easily save $160 per month if we refinanced and got that even-lower interest rate.

However, our closing costs would be sky-high, mostly because we’re in the NYC metropolitan area and costs for things such as title searches and lawyer fees are higher than in much of the country.

Closing costs can include these fees:

• Title search
• Title insurance
• Attorney fees
• Home inspection
• Survey
• Credit check
• Mortgage application fee
• Points
• Local taxes & transfer fees

Generally, I’m more of a fan of paying down mortgage debt by making extra principal payments — whether biweekly, monthly or yearly (or anything in between that’s sanctioned by your mortgage lender). If you won’t be penalized by your lender, pay more than the monthly payment, but make sure that it goes to the principal, not to escrow. We’ve been paying an extra $25 each month from the very first mortgage payment. While it doesn’t sound like a lot, it adds up: Even if we never increase that extra payment from $25, we’ll have shaved a full year off our 30-year mortgage, saving $11,500 in interest overall.

Doing the Math

Using our previous closing costs as an estimate, we’d have to cough up more than $7,000 to refinance to the lower interest rate. And it would take almost 4 years to recoup those costs and make the refinance worthwhile. Now while that seems like a long time, here is an interesting breakdown of our options and how they affect interest payments.

1. Keep Paying Original Mortgage. With no extra payments, our interest costs are nearly as much as our actual mortgage balance.

2. Keep Original Mortgage, But Make Extra Payments. As I previously stated, for us, paying an additional $25 per month toward the principal knocks off $11,500 in interest by the end of the full original 30-year mortgage term.

3. Refinance to a New 30-Year Fixed Mortgage. We could lower our interest rate by .75%, which equals a monthly savings of $160. However, I estimate that our closing costs would be $7,000. On the surface, this option makes the most financial sense because the total interest savings would be $44,000 after 30 years ($51,000 minus the $7,000 in closing costs), as compared to option 1. But we’d either have to pay that $7K in closing costs in cash or roll it into the newly refinanced mortgage, which would bring us right back to our original mortgage amount, albeit with lower monthly mortgage payments. And it also doesn’t take into account the interest we’ve paid thus far on our original mortgage (about $17,000). So really, the overall interest savings would be closer to $27,000.

There is a fourth option: Increase the extra monthly payments on the original mortgage. If we increase our extra principal payment to $95 per month, we would see the same interest savings as offered by refinancing — AND knock 3.5 years off our original 30-year mortgage term, rather than extending the time it’ll take to pay off our home.

Keep in mind that refinancing ‘resets’ your mortgage — it’s another full 30-year term, which may not be attractive to older homeowners who don’t want to be paying for their house into their retirement years, especially if they’ve already made 10-15 years of payments into their original mortgage.

Which is the best option? It’s hard to say, because it depends on individual circumstances. If all you want is a lower monthly interest rate in order to better fit your budget, then refinancing might be right for you, as long as you’re okay with the extra time it will take to pay off your home. If you don’t plan to own the house for very long, there’s almost no benefit to refinancing because of the closing costs. And if you’re underwater on your home, lenders likely won’t give you the best rates.

As always, crunch the numbers and do your homework before making any major financial moves.