As a homeowner, we’re sure you’re aware that the mortgage is your most significant monthly expense. If you have equity in your home, then you might be thinking about refinancing to help you get into a better financial position.
However, do you have any idea of when it’s a good time to refinance? There are do’s and don’ts when it comes to this situation. In some circumstances, taking advantage of a refi offer can benefit you, but there are times where it’s not a good idea as well.
With the Federal Reserve cutting rates for the first time in four years, American monetary policy is switching gears and heading back toward the zero-percent level. The Fed is reversing monetary policy to try and stimulate the economy away from the chances of a recession. For many homeowners and home buyers, this is good news. Lower rates mean lower monthly payments on your mortgage.
We decided to give you everything you need to know about refinancing your home, and the best time to pull the trigger on a new deal with a lender.
How Changes in Interest Rates Affect Your Mortgage
- 1 How Changes in Interest Rates Affect Your Mortgage
- 2 The Present Interest Rate Climate and How It affects Your Mortgage or Refinancing Deal
- 3 Refinancing Explained
- 4 Timing the Market for Refinancing Deals
- 5 Justifying Refinance Costs
- 6 Are You Going to Sell in the Future?
- 7 Wrapping Up – Is your Credit Score Healthy?
Knowing how the interest rate affects your mortgage requires you to get an understanding of the prime interest rate and the Federal funds rate. The Federal funds rate is the rate at which banks charge each other interest for loaning money overnight. Legislation demands that all banks keep a reserve equal to a specific percentage of their total deposits, in an account held at a regional Federal Reserve bank.
The prime interest rate defines the rate at which the banks loan money to the consumer market. When you are thinking about taking on a mortgage or refinancing, the banks charge you the prime interest rate.
However, banks reserve the prime interest rate for their best customers, and you need a stellar credit score, along with a flawless payment history to receive prime on your mortgage. In most cases, the banks provide loans to consumers at one or two percentage points above the prime rate.
It’s also important to note that the prime rate mostly moves in lockstep with the Federal funds rate. Being that the Federal Reserve is starting to cut rates again, initiating the next easing cycle for the economy, the prime rate also took a cut in early August, with the Fed announcing a cut in the Federal Funds rate from 2.5-percent, to 2.25-percent.
As of August 2019, the prime rate fell from 5.5-percent to 5.25-percent, reflecting the Federal Reserve’s move toward a lower interest rate target. Many analysts on Wall Street expect the Fed to continue cutting rates for the duration of 2019 and 2020, heading into the next presidential election.
However, no-one knows how and when the Fed will induce their next rate cut, and if it will also change the prime rate as well. One thing we can be sure of is that interest rates are headed lower, at least in the short-term.
The Present Interest Rate Climate and How It affects Your Mortgage or Refinancing Deal
With rates set to head lower, consumers already see dollar signs flash in front of their eyes. Lower rates mean that the cost of borrowing money is getting lower. If you purchased a home in 2016, at the start of the last hiking cycle by the Federal Reserve, then you would have attained an interest rate on your mortgage of 3.5-percent.
Most Americans choose a fixed-rate mortgage deal, which means that they got a 3.5-percent interest rate on their mortgage if they applied in December 2015. As interest rates steadily rose to the 5.5-percent level in December 2018, they scored on their mortgage. A fixed-rate mortgage locked them into the prime rate of 3.5-percent, even though interest was starting to climb.
This timing of the market saved homeowners a bundle on their mortgage payments through the use of a fixed-rate mortgage. However, those American’s that bought real estate on December 2015, and decided to use a variable-rate mortgage, got taken to the cleaners as interest rates rose over the following four years.
An adjustable or variable-rate mortgage means that your mortgage rate tracks the prime rate. Therefore, if you got into the mortgage with a 3.5-percent rate, then you are now paying 5.25-percent, (plus the points added by the lender.) Thus, your mortgage payment would steadily increase with each hike by the Fed.
Refinancing your mortgage means that you extend your current mortgage back to the full term, allowing you to benefit from access to the equity accrued in your home since you first started making payments on the loan. Therefore, if you purchased your home for $250,000, and have since paid $50,000 into the mortgage facility, you now have $50,000 in home equity available through a refinancing deal.
If you refinance your mortgage, you will withdraw the $50,000, and the bank or lender would extend your payment back to the original date. You may find it shocking that people are willing to take the risk of pulling the equity out of their home, but it’s a common occurrence in the real estate market.
There are various reasons why people would want to draw the equity out of their home and return their mortgage to the full term length. Maybe you want to put a down payment on an investment property to earn your income? Perhaps you’re thinking about remodeling a few rooms in your house, or you need access to capital for your kids’ education. Whatever the reason, it’s personal, and the banks don’t inquire about your motive for refinancing.
All the banks and lenders are interested in when you apply for a refi deal, is that you made all of your payments on your previous mortgage, and your credit score is healthy. The banks make money from lending you money, and it’s in their interest to make as many loans as possible to increase their balance sheet and show a profit to their shareholders.
Timing the Market for Refinancing Deals
So, when is it a good time to get a refinancing deal on your mortgage? Well, if we are going by current market conditions, then there are a few answers to this question.
If you currently have a fixed-rate mortgage, and you got it back in 2015 when prime interest rates were at 3.5-percent, then it doesn’t make much sense to refinance right now. With interest rates currently sitting at 5.25-percent, you’ll end up paying 1.75-percent more interest on the new deal, than you would with the original mortgage.
Therefore, this strategy doesn’t make financial sense to any homeowner, unless you are in a desperate situation, or you have a great deal available on an asset that earns you more income than the additional interest you’ll be paying on the mortgage. For example, if you are buying a rental property, and have a positive cash flow from day one that covers the additional costs involved with your monthly repayments.
However, if you are pulling out the equity for remodeling or other lifestyle expenses, then it’s a poor financial decision, and you’ll end up costing yourself more money on your mortgage payment at the end of the month.
On the converse side, if you received a mortgage in December of 2015, and made the mistake of taking an adjustable or variable rate mortgage, then it may be a good deal. A variable-rate mortgage would have seen your monthly payments rise steadily over the last 4-years to a peak in December 2018 through to July 2019.
Therefore, refinancing your mortgage right now with another variable-rate mortgage would allow you to benefit from the coming year’s interest rate cutting cycle by the Federal Reserve. As the prime rate falls in conjunction with the Federal funds rate, your mortgage payments will steadily decrease over the years.
Justifying Refinance Costs
Refinancing your mortgage has other costs that you need to take into account before you sign the paperwork. Just as when you got your first mortgage, there are closing costs involved with your refi deal as well.
Closing costs can account for between 3 to 5-percent of the total value of the deal. Therefore, if you refinance $50,000 of your home equity, you can expect to pay between $1,500 to $2,500 in closing costs, depending on the terms offered by the lender.
When it comes to closing costs on refi deals, lenders are always more likely to charge you toward the high side, as they know you need the money. While this may seem like a predatory lending strategy by the banks, it’s the way they choose to do business, and you have to play along.
If you are refinancing your mortgage in an attempt to get a better deal on your monthly payment, then you need to factor the closing costs into your monthly payment cycle. For example, if you only got your mortgage three years ago, and you want to refinance, the $3,000 in closing costs would mean that your monthly payment reduction would need to be less than $100 for the deal to make any sense, or you are losing money on the refi.
Are You Going to Sell in the Future?
If you are refinancing and intend on selling your home in a few years, it’s not worth the extra expenses involved with the closing costs and refinancing charges. In this case, you are better off waiting it out until you decide to move and then selling up to gain access to the equity in your home.
Using this strategy saves you on the closing costs, and allows you to gain more money on your sale as the property market starts to move up. Real estate appreciates over time, and you may find that your $200,000 home you purchased 5-years ago, is now worth around $220,000. When you sell your property, you can ask for a higher selling price, and bank the extra profit you made on the sale.
When interest rates start to go lower, it stimulates the economy. As a result, more people begin to buy real estate that couldn’t afford it when interest rates were higher. This reduction in interest rates entices a sellers’ market, as there are more buyers, allowing you to sell your home for more while increasing your chances of attaining the selling price you want.
Property prices rise depending on the location and condition of your home. For example, if you live in a school district, your property price is likely to increase faster than if you live in an area of the state where an oil company decides to start a fracking operation on the outskirts of town.
As with any other investment in your portfolio, you need to take the market into account when planning your exit strategy.
Wrapping Up – Is your Credit Score Healthy?
Another vital consideration to take into account when applying for a refinancing deal is your credit score. If you purchased your home five years ago, and had a credit score in the 700s or 800s, and have since fallen on hard times financially, then your credit score may be lower than it was when you first took out your mortgage.
Your credit score determines the interest rate the bank charges you on your mortgage facility. Most Americans with good credit scores in the 700s will receive prime plus two points. However, if you are a good customer and increase your credit score into the 800s since you took your mortgage, you may qualify for a point or two less than you are currently paying, which could save you a bundle on your monthly repayments if you choose to refinance.
However, on the flip side, if your financial position worsened, and you started to miss a few payments on your credit card or other credit facilities, your credit score might be significantly lower. As a result of your lower score, your refinancing deal could end up being set at prime plus three or four points, adding substantially to your monthly mortgage payment.
Check your credit score for free with the credit bureaus before you think about refinancing your home.