I get this question a lot from friends and clients: “Should I refinance my mortgage?” The answer is not always so simple. In fact, many of us thought the days of refinancing were almost over (well…not literally) because so many people who purchased homes or refinanced over the last few years have received such low rates that the thought of getting even a lower rate seemed unlikely. At the very least, you might want to explore the possibility of refinancing your current mortgage. Before I get into what to consider before deciding on whether refinancing makes sense, let’s take a quick look at how rates are generally set and how they have changed over the last year or so.
How are mortgage rates determined?
There are many factors that go into setting mortgage rates, but one of the most widely used benchmarks to determine if mortgage rates are headed up or down is the 10-year US Treasury bond. Why?
As most of us know, the typical mortgage sold to consumers is the 30-year mortgage. However, the reality is that many mortgages are either refinanced or paid off within 10 years. Therefore, the 10-year US Treasury bond is a great benchmark to determine the direction of mortgage rates. Generally, the 30-year mortgage is about 1.60%-1.70% higher than the 10-year US Treasury bond. The typical mortgage sold to consumers is the 30-year mortgage; however, the reality is that many mortgages are either refinanced or paid off within 10 years. Therefore, the 10-year US Treasury bond is a great benchmark to determine the direction of mortgage rates. The 30-year mortgage is usually about 1.50%-1.70% percent higher than the 10-year US Treasury bond because the US Treasury bond is guaranteed by the US Government. In fact, according to the Federal Bank of St Louis, the last three years the spread has been 1.7%. So, given that the 10 year is at approximately .58% (which is something I didn’t think I would ever see) would mean that 30-year mortgage rates should be about 2.25% to 2.5% but that isn’t the case. It stands at about 3.0%. So why isn’t the rate falling in lockstep with the 10-year bond like it usually does and maintain about a 1.7% -1.9% spread? There are many reasons but here are a few:
- Investors who are looking to invest for a 10-year period may decide between the 10-year US Treasury bond or a mortgage backed security (MBS). An MBS is an investment where its value is determined by the underlying mortgages and investors who buy them will demand a certain interest rate so this could force lenders to keep rates higher.
- Believe it or not but lenders are keeping the rates higher because demand has been so great that if they go lower, they will not be able to keep up with applications and potentially lose more customers due to lack of client service.
- Investors make money when they collect interest payments on mortgages over the long term but if rates drop further then refinancing picks up and mortgage investors lose out and lenders are aware of this.
What are mortgage rates today and where were they a year ago?
If you told me in August, 2019 that the 10-year US Treasury bond (1.63%) and mortgage rates (30 year average at 3.62%) would be lower right now, I would not have believed you. In fact, during the summer of 2019 a few mortgage professionals told me that the refinance business was extremely slow because so many people already have low mortgage rates and they didn’t see it getting better any time soon, if at all. Well, think again!
The average 30-year mortgage rate in April 2019 was anywhere from 4.30%—4.50%. However, as of today, the average 30-year mortgage rate is between 3.00%-3.40% depending on the institution, points paid, your credit score, equity in home and other various factors. So, if you have a current mortgage rate greater than 4.00%, it just may be time to think about refinancing.
How do you determine if refinancing makes sense?
The rule of thumb that many subscribe to is if current mortgage rates are not 1% or lower than your mortgage rate, refinancing makes no sense. In my opinion, there is more analysis to it than the rate alone. You must look at your own personal situation with respect to how many years left on your mortgage, your current mortgage payment and closing costs and just crunch the numbers. This will go a long way in making your decision.
Reasons for refinancing
There are many reasons why people refinance: to shorten the life of their mortgage, refinance for more than their mortgage amount in order to use extra cash for other reasons, or converting a variable interest rate mortgage to a fixed rate mortgage. However, most common reasons people refinance are to get a lower interest rate or to lower their monthly payments. This usually results in extending the term of their mortgage. While this will reduce their monthly mortgage payment, they will end up paying more total interest over the life of the mortgage. If you still decide to refinance knowing this, there are factors you need to consider in making the final decision.
What to consider before you refinance
You want to ensure that your monthly savings from refinancing will pay back the closing costs that are associated with refinancing within a relatively short period of time. You can determine how long it will take to recover your closing costs by taking this amount and divide it by the amount you will save each month from refinancing. For example, if your closing costs are $2000 and your monthly savings each month from refinancing is $100 per month, then your costs will be recouped in 20 months. If you move before you recoup these costs to refinance, you really will not be saving any money. So determining how long you will be staying in your home is extremely important in making the decision to refinance.
As previously mentioned, the interest rate alone should not determine whether you refinance. There is no one size fits all formula for determining whether to refinance but a little time spent analyzing may go a long way in helping you determine what is best for you. As always, you should seek the advice of a financial advisor to discuss your personal situation.
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