Homeowners who are considering a mortgage refinance are usually told it makes sense if they can shave at least 0.75% off their mortgage interest rate. But is it worth refinancing for 0.5% or less?
The answer may be “yes,” depending on your goals, how long you plan to stay in your home, and whether you have to pay closing costs upfront.
Refinancing to save 0.5%
When you refinance a mortgage, a lower interest rate can reduce your payment and save you money on your home loan. To crunch the numbers, use a mortgage payment calculator.
In general, refinancing for 0.5% only makes sense if you stay in your home long enough to break even on closing costs.
Let’s say you took out a 30-year fixed-rate mortgage for $200,000 and put down 20%. With a 3.75% mortgage rate, your principal and interest payment amounts to $740 per month.
You then decide to refinance your mortgage a few months into the loan. A lender quotes you a refinance rate of 3.25%, which lowers your P&I payment to $696 and saves you $44 a month.
Breaking even on a refinance for 0.5%
When you get a refinance rate quote from a lender, they’ll give you an estimate of your new monthly mortgage payment and closing costs. These closing fees usually average $5,000, but they’ll vary with every loan.
Because you’re paying to close on the refinance, you won’t truly see savings until you recoup the loan costs — also known as your breakeven point. You can calculate your breakeven point by dividing your monthly savings by your closing costs.
Here’s what your breakeven point would be if your closing costs equal $5,000 and monthly savings are $44:
$5,000 / $44 = about 114 months, or 9.5 years
In this example, refinancing your mortgage might not be worth it if you’re planning to move within the next nine years. But if you stick with the mortgage over the entire 30-year term, you’ll save $15,840 in total interest.
A modest change in mortgage rates affects the breakeven point, so calculate this time frame on all your mortgage estimates. In the table below, you can see a breakdown of how long it takes to recoup closing costs on a loan worth $200,000 at various interest rates:
How do you get the best home loan refinance rate?
Mortgage refi rates are based on a combination of the borrower’s financial health and macroeconomic factors. While you don’t have much influence over the economy, you can take steps to increase your chances of lowering your rate by 0.5% or more. Here’s how:
1. Improve your credit score
Your credit score heavily influences the mortgage rate you receive. And while most mortgage programs come with a minimum credit score, a higher score generally helps you qualify for a better rate.
If your credit score is on the lower side, consider improving your credit score before applying for a refinance.
2. Pay closing costs upfront
A no-closing-cost refinance is a type of mortgage where the lender doesn’t require closing costs. But it’ll typically make up for this by charging a higher interest rate, rolling the closing costs into the loan, or both.
While a no-closing-cost refinance is convenient, you’ll likely pay more over the life of your loan because you wind up paying interest on the closing costs.
3. Compare lenders to find the best possible rate
One lender might offer a great mortgage interest rate, while another lender might be willing to compete for your business with lower refi costs, especially if your credit is strong.
But you won’t know what is out there until you shop around. That’s why it’s important to gather at least three refinance quotes and compare the closing costs and interest rates to find the best mortgage lender for you.
Reasons to refinance your mortgage
Many homeowners refinance to take advantage of a better interest rate, but there are other reasons to refinance as well. Here's when refinancing is worth it:
Lower your monthly payment
If you refinance a mortgage several months or years into the loan term, then your monthly payment may drop for two reasons:
- The new loan is based on a smaller principal balance, which shrinks your payments.
- The lower rate cuts down on your interest costs.
That lower monthly payment could give you a lot of breathing room in your budget.
Learn More: Mortgage Points: What Are They and Are They Worth It?
Pay off your mortgage faster
You might want to pay off your mortgage before retiring so you don’t have to worry about this expense while living on a fixed income. You can do this by refinancing a loan with a shorter term.
For example, if you have 20 years left on your 30-year loan, you could refinance to a 15-year loan. Shorter-term loans typically come with lower interest rates, but you’ll pay more per month. Make sure you can handle the higher monthly expense before committing to the new mortgage.
Learn More:
Switch to a different loan type
With an adjustable-rate mortgage (ARM), the mortgage rate typically starts at a low, fixed rate for a pre-specified term. After the fixed period ends, the rate may increase or decrease for the remaining loan term.
ARMs can be a good choice if rates recently dropped and you want to secure a low initial rate or plan to sell in a couple of years.
The opposite is true, too. If you originally took out an ARM but now prefer a predictable payment, then you may refinance into a fixed-rate loan.
Pay off higher-interest debt
A cash-out refinance allows you to take out a mortgage for more than you owe. The old loan is paid off and you get to keep the difference, minus the closing costs.
While this increases the amount you owe, a cash-out refi may save you in the long run if you use the extra cash to pay down higher-interest debt.
Pay for a large expense
You can also use the funds from a cash-out refinance to cover the costs of a large project, such as a home improvement.
Because home improvements may increase your home value, this could be a good way to invest in your home and potentially recoup the costs when you later sell.
Find out: What Documents Do You Need to Refinance Your Mortgage? A Checklist
When not to refinance
Refinancing isn’t right for all homeowners — so if you’re considering this move, it’s important to determine how refinancing may benefit you.
Here are two scenarios in which it might not make sense to refinance:
You plan to move out soon
To figure out if a refinance makes sense, you’ll need to calculate when you’ll break even on your closing costs.
It would take you 20 months to recoup $4,000 of closing costs when your monthly savings equal $200, for example. But if you plan to move within two years, then you actually lose money in the deal.
You’ll end up paying more in interest
Saving money might be why you’re refinancing, but you could actually pay more over the life of the loan in some cases.
For example: Say you took out a 30-year mortgage at 4.5% a decade ago and you’ve paid about $71,137 in interest. You refinance this year into a new 30-year mortgage at 3% — if you pay down the loan over this new time frame, you’ll end up paying $64,473 on the new loan.
But if you had stuck with the original mortgage, your total interest costs would have been lower. To avoid paying extra interest, you might consider refinancing into a shorter-term loan.
Here’s how the costs ultimately break down:
- The interest you’ll pay with the refinance: $135,610
- The interest you would have paid had you not refinanced: $132,129
By not refinancing, you would have saved $3,481 in interest.
