For those that chose a fixed rate over an adjustable rate mortgage to finance their purchase there may come a time when that initial decision might be changed. How so? Mortgage loans today don’t have prepayment penalties on them and they can easily be replaced by refinancing the existing loan into another one. That said, when does it make sense to refinance an existing fixed rate mortgage?
There are two primary reasons why it can make sense to refinance a fixed rate loan- lowering the rate or changing the term. Or both at the same time. Yet for those thinking of refinancing one thing they should not do is simply compare the current market rates with the one they have on their existing mortgage. There seems to be somewhat of a financial myth that occasionally floats around that people shouldn’t consider refinancing unless current rates are 1.00% or 2.00% lower than what they currently have. But that’s not how to decide whether a refinance makes sense. Instead, compare the difference in monthly payments. And no, that’s not the same thing.
There are fixed costs on all mortgage and those that are calculated based upon the amount of the loan. An origination fee for example will cost more on a larger loan amount compared to a smaller one because a 1.00% origination fee is 1.00% of the loan. That equates to $4,000 on a $400,000 home loan and $750 on a $75,000 mortgage. There are costs that are fixed such as a lender’s underwriting fee or the cost for an appraisal. When deciding to refinance, both types need to be accounted for.
Instead of just considering the rate, compare the differences in monthly payment with the cost to refinance. If you will own the home or otherwise keep the fixed rate mortgage longer than it takes to recover the closing fees with the new loan, it might make sense to refinance a fixed rate mortgage to one with a lower rate. If closing costs are $3,000 and the new monthly savings is $150 per month then it would take 20 months to recoup the fees associated with the newly refinanced loan.
It can also make sense to refinance an existing fixed rate mortgage to change the loan term. Most lenders offer loan terms in 10, 15, 20, 25 and 30 year increments. The shorter the term, the less interest paid to the lender over the life of the loan. A 30 year mortgage term will provide lower payments and is one of the reasons it is the most popular choice for a fixed rate term but changing from a 30 year fixed rate to say a 15 year rate can save thousands in interest payments.
Your loan officer will be more than happy to provide you with the different monthly payment scenarios as well as take a look at when refinancing a fixed rate loan makes sense. There are other loan options such as a hybrid that might be even better than another fixed rate loan as well, so be open about your different choices and select the right mortgage choice for your situation.