Thinking of Refinancing... Well, Think Again!

Many homeowners recently purchased a home in the last couple of years that has an interest rate in the 7 – 7.25% range, and with the recent news of the Federal Reserve lowering the federal funds rate for the first time in 2 years, a lot of them are thinking about refinancing their home.  Sounds like a good idea, right?  Well, maybe, or maybe not, depending on the situation.  Before we get into the economics of it, first, let’s understand what the Federal Reserve interest rate means and how it impacts the economy. 

The federal funds rate is not the rate you pay for a mortgage loan; it is the rate at which the central bank loans money to other banks, otherwise referred to as the bank’s cost of funds.  Based on the bank’s cost of funds, you see the advertised rates for mortgages and other loans.  The banks, like any other business, have an overhead and a need to turn a profit.  You will see rates advertised as 1 – 2 percent higher than the federal funds rate for mortgages typically, which are longer-term debts with fixed yields.  In addition to the rate spread, the banks will also have fees on the borrowing transaction, which go towards their overhead and profit margins. 

When the Federal Reserve lowers the federal funds rate, banks pay less to borrow money from one another.  Banks, in turn, lower interest rates on loans (including mortgages) and credit cards, lowering the costs of borrowing money to buy cars, homes, and other big purchases.  All these factors are intended to induce economic growth.  With borrowing costs lowered, consumers have an incentive to spend and invest more.  This is why you see housing values and sales spike during lower interest rates because borrowers can “afford more houses” because of a lower interest rate.  

Now that we have a basic knowledge of the Federal Reserve, let’s dive into whether the time is right to refinance your home or not. For the sake of the math on this discussion, I will use national home averages and interest rates, keeping in mind that your situation may be different and may require some additional consultation.  

In the last 18 months, the national average for a home was approximately $412,000. For the sake of this analysis, I am going to assume that the home was purchased with conventional financing and that the payment is principal and interest only, this will help keep things simple and avoid us having to calculate things like mortgage insurance, local property taxes and other borrowing costs that are associated with loans that do not have 20 percent down payments. We will also assume that the mortgage rate was 7% and that the borrower paid the customary closing cost for the loan.

Typically, closing costs for a home are anywhere from 2 – 6% of the purchase price. So, for the purchase price in our example of $412,000, you can expect a range of $8,240 to $24,720, which is a wide range.  In my experience, if you are putting 20% down on a loan and have moderately decent credit, you are going to be on the lower side of this range, so we will use $10,000.  This $10,000 will cover things like your appraisal fees, lender fees, real estate attorney fees, title insurance, recording fees, and other costs associated with the transaction.  

We will use the national home average value as our purchase price with a 20% down payment as an example, so that would put the amount borrowed at $329,600. 

Using a free mortgage calculator (and there are several you can find online or in the app store on your phone, the one I like to use is this one: https://mortgagesolutions.net/mortgage-calculator/  because you can add in the taxes (assuming you have the correct tax rate) as well as insurance to get a full monthly payment, without having to look at a bunch of advertisements for bank loans)  We get a monthly principal and interest payment of $2,193 per month.  

If you are only 18 months into this loan, you have been paying primarily interest with little principal reduction.  Assuming your refinance is to just lower your monthly payment, your new mortgage balance would be just shy of $325,000, with you paying down just over $4,000 in principal reduction and just over $34,000 in interest payments (You can calculate this by utilizing a free mortgage calculator with amortization schedule.  I like to use this one here https://www.calculator.net/amortization-calculator.html  which also has the regular mortgage calculator function but does not have the interest and insurance component like the one I mentioned above.)  

Now, you are 18 months into this loan and have paid $10,000 in closing costs as well as $34,000 in interest. Your payment is $2,193 a month, and you want to determine if refinancing is right for you.  Assuming you are not pulling cash out of the transaction, borrowing $325,000 at today’s current interest rate of 6.1%, you will have a new monthly payment of $1,970, which is a reduction of $213 per month; however, you will be resetting your loan back to a full 30 years as opposed to being 18 months in, and you will have an additional closing cost of approximately, which tends to be right about the same as a home purchase unless you are getting a special from a bank, which does vary from bank to bank and market to market.  For this example, you can anticipate another $10,000 in closing costs, and do not be fooled by lenders telling you that you can just roll the closing cost into the new loan amount. Yes, you surely can do that, but that not only means you’ll be paying them back over time but also paying interest on them that is compounding. 

To save the $213 per month, you’ll be spending $10,000 in new loan closing costs, and to get to the same amount of time of paydown that you did on the previous loan, you will have spent an additional $31,318 in interest.   Even taking the interest you are spending out of it, which you shouldn’t because that is sunk money you will never recover, you will not recover the new closing cost of $10,000 in savings until you are 47 months, or one month shy of 4 years, into the new loan.  Refinancing this soon into your loan with rates only being 1% less than what you are currently paying does not make much economic sense; however, if your reasons to refinance are different, such as you are looking to get cash out for a new investment, a life status change or some other reason then instead of a refinance you should look at other options such a HELOC (Home Equity Line of Credit).  The closing costs of HELOC are generally under $1,000; they are fast and easy to renew.  You will pay a few hundred dollars each year to renew it with your bank, and the rate is higher by a couple of percent, but you only pay interest on the amount you pull out and use, and if rates drop in the market, your HELOC rate should fall with it. 

Remember, each person’s financial situation is different and may require some additional analysis or factors to be considered.  I suggest before you make the decision that, you consult with your financial advisors, who have a complete understanding of your whole financial future, and then make the decision that is right for you.

Jesse Brewer has been a real estate broker and investor for over 25 years, as well as an elected county commissioner in Boone County.