Refinancing your mortgage could save you hundreds of dollars a month for years, or it could cost you more than it’s worth. With interest rates expected to rise again soon, how do you decide what’s right for you? Let’s explore what you need to know.
Current Interest Rates and You
Simply put, an interest rate is the cost to borrow money. When you borrow money, you pay back what you borrowed (the principal) plus some extra (the interest) to compensate the lender.
When you deposit your money into a savings account, certificate of deposit or money market account, you’re effectively lending those funds to the bank, so the bank compensates you by paying you interest.
When interest rates rise, as they’re doing now, you pay more to borrow, but you also earn more when you save.
How the Fed Affects Mortgage Rates
There are many different interest rates out there, but they’re almost all affected by the Federal Reserve’s target rate, which the Fed sets to help achieve its goal of a strong U.S. economy. The Fed adjusts its target based on various economic conditions, and by historical standards, interest rates have remained low for almost two decades.
In June 2006, before the Great Recession, the target rate was 5.25%. The Fed started lowering it in 2007 in response to the financial crisis and didn’t stop until late 2008, when the target essentially reached zero. There it remained until 2015.
Since 2015, the Fed’s target has fluctuated. First, the target rose as the economy grew. Then, the Fed lowered the target due to the COVID-19 pandemic. Most recently, the central bank has raised its target rate to combat inflation. Throughout it all, the target has stayed much lower than 5.25%.
In fact, even after two increases so far this year, the target range now stands at 0.75% to 1%.
Mortgage rates are higher than the Fed’s target rate, in part because lenders need to make a profit to stay in business, but it’s the direction of the rate that matters now. The Fed’s increases have raised mortgage rates, and the Fed may raise rates again this year, which could increase mortgage rates even further. Indeed, the chief economist for the Mortgage Bankers Association expects mortgage rates to hit 4% this year.
When Should I Refinance My Mortgage?
Mortgage rates are just one factor to consider when deciding whether to refinance.
First, think about why you want to refinance. For most homeowners, the point of refinancing is to lower the overall mortgage cost. A lower mortgage rate will often lower your monthly payment, but that doesn’t necessarily mean you’ll save money in the long run.
Here’s how this could happen. Refinancing will not change the amount of equity you’ve built up in your home, but it could set you back in the amortization process. Every time you make a mortgage payment, some of the money counts toward the principal and some counts toward the interest. With many mortgages, the majority of each of your early payments goes toward interest. Over the years, that shifts, and most of each payment goes toward principal.
Imagine you’ve been paying toward a 30-year mortgage for five years. Most of your money has gone toward interest, not principal. Refinance to another 30-year mortgage, and you will keep about the same level of principal, but now most of your payments for the next several years will again go to interest.
And your new mortgage will last for 30 years, not 25. You may see a lower monthly bill but very little savings in the long run. If you hope to save money by refinancing, be sure you calculate your total savings, not just your monthly savings.
Another reason to refinance is to change the length of your mortgage, say from a 30-year loan to a 15-year loan, or to switch from an adjustable-rate mortgage to a fixed-rate mortgage.
If you have an adjustable or variable rate mortgage now, refinancing to a fixed-rate loan before interest rates potentially rise again could save you money for decades and alleviate the stress of fluctuating payments.
If you have a 30-year loan and want to switch to a 15-year loan, now is also a good time to consider refinancing. Rates are low, and 15-year loans often have lower rates than 30-year loans, so you could save even more. Just know that your monthly payment will be higher than with a 30-year loan.
No matter why you’re refinancing or what kind of loan you want, also know that rising rates could create a rush to refinance, increasing the competition for loans. Starting early (so you can beat that rush) and shopping around (so you can secure the best deal) may help you.
How Much Would Your Rate Change?
As you shop around, remember that a lower interest rate could save you money, but only if the rate is low enough to make up for the costs of refinancing (because there are costs, which we’ll explore shortly). Rates have been low for so long that you may already have an excellent deal.
However, you may now qualify for a lower rate if your credit score is higher than it was when you bought your home. Be sure to avoid other large purchases that could disrupt your credit before completing your refinancing. Hold off on taking out that car loan, for example, until after you’ve finished refinancing your mortgage.
And know that refinancing itself will temporarily lower your credit score, so plan accordingly. You can submit multiple refinancing applications within a 14-day window to up your chances they’ll be treated as one inquiry on your credit report.
Factor in Closing Costs
We’ve mentioned refinancing comes with costs. So how much will those costs be? You’ll likely pay between 3% and 6% of your outstanding principal to cover origination fees, appraisal fees, title insurance, title search fees, legal fees and more.
You can’t avoid these fees entirely, but some lenders will roll them into your loan, in which case you’ll spread the costs over time but end up paying interest on them. You can also get a “no closing costs” refinance that typically comes with a higher interest rate, which could cost you more in the long run than paying the fees upfront would.
Again, it pays to shop around to find the best deal. Consider credit unions, local banks and online lenders, and be sure to ask for a breakdown of all the costs so you can accurately use the mortgage refinancing rule of thumb we’ll introduce in a moment.
If you’re considering refinancing through your current lender, you can also ask if they’ll waive any fees. Some lenders may agree to try to keep you as a customer.
Mortgage Refinancing Rule of Thumb
Now that you know your potential refinancing costs, here’s a quick rule of thumb.
Divide your refinancing costs by the amount you’ll save each month with the new loan. That’s your break-even point, or how long it’ll take you to recoup your costs. Say you’ll pay $200 less per month for your new mortgage, but you’ll spend $4,000 to refinance. Divide $4,000 by $200 to get 20 months, or just under two years, to break even.
Compare that time frame to how much longer you plan to stay in your home. Does refinancing still make sense for you?
Home Improvement Time
If you’re thinking of renovating your home, you may want to consider a cash-out refinancing, which allows you to get a mortgage for more than what you currently owe. You can use the extra money to build that addition or redo your kitchen, all while saving money with a lower interest rate.
Just remember that if you end up borrowing so much that you have less than 20% equity in your home, you’ll have to pay private mortgage insurance, an extra monthly cost.
Home equity lines of credit (HELOCs) are another way to secure funding for home improvements, and they can be more flexible than refinancing. Rather than taking out a new loan, you set up the line of credit and draw on it when you want the money.
The rate you pay on the money you borrow is tied to the Fed’s target rate, so HELOCs have low rates now that could rise soon. You can fix portions of what you borrow using a HELOC, though, so they may be a good option for you, depending on your plans for the money.
Your Mortgage as a Budget Line Item
Let’s say refinancing makes great sense for you: You’ll save each month and over the life of the loan. Excellent. Now, don’t forget to make smart choices with your savings.
A high yield savings account gives you flexibility, so use the money for an emergency fund, a vacation or that new phone you’ve got your eye on. And remember the positive side of higher rates—you earn more on what you save.
Elizabeth Whalen is a freelance writer based in Seattle. She loves writing about business, financial services and sustainability.