Will the Fed’s actions to lower mortgage rates make it a no-brainer to refinance?

December 14th, 2008 · No Comments

I’ve read a number of recent news items that indicate the government is thinking about taking action to push the 30-year fixed mortgage rate down to around 4.5%. I’m not sure my wife and I are their target market for any resulting action, but this is a lower rate than we’re currently paying on our mortgage and it may be by a big enough margin that we should be planning to refinance our home if rates do drop.  I did a bit of research about refinancing and here’s what I found.

First, why would we even consider refinancing?  My first thought was that refinancing could simply save us money by lowering the interest we have to pay over the life of the loan.  However, refinancing has a cost and we’d need to see what the break even point would be to decide if it is worth it.  I’ve also thought it could be nice to switch to a shorter, fixed rate, 15-year term without having to raise my monthly payment too much. That could help us reach our geographic independence goal sooner because we’d have significantly lower expenses once the mortgage is paid off.  Finally, there’s always the possibility of trying to cash out some equity to use the money for more productive purposes — investing or trading or something — though I can say I’m reluctant to do it for anything high-risk and I expect my wife to be even less willing.

Having come up with some confirmation that it’s worth thinking about further, the next task was to think about when we’d break even on the cost of the refinancing.  Would we even be in the house long enough to break even?  While I recognize there are any number of things that could change our lives at any time, we don’t currently have any plans to move and life seems as stable now as it ever has.  (I hope I’m not jinxing us by saying that!)  Apparently, conventional wisdom is that we shouldn’t refinance unless our rate will drop by 2 percentage points. At that difference, the rate change will break even around two to three years for a “typical” conventional mortgage. However, the balance may shift in favor of refinancing at a smaller rate drop if our principal balance is high, or the cost of the refinancing is low.  Let’s investigate with some real numbers.

Any simple mortgage calculator will show that we’ll save about $60 to $65 per month for each $100,000 in loan value if our 30-year fixed rate drops by 1% and our starting rate was in the 5% to 6.5% range.  As a more specific example, for a $300,000 loan with a starting rate of 6.5%, a 1% drop saves us $2,314 in payments per year.  A 2% rate drop to the fed target of 4.5% would save us $4,513 per year for that same $300,000 loan.  But those savings are only one side of the equation.  How much does refinancing actually cost?

Unfortunately, there are no exact rules to go by here, nor are there any real national standards for loan costs.  Apparently, some sites suggest a rule of thumb where an average refinance costs something like 3% to 6% of the refinanced principal (which is where the earlier assumption of not breaking even for two to three years comes from.)   But my own quick survey of estimates from a couple lenders websites shows that most of the fees are fixed, so I can’t imagine the cost being that high a percentage for a $300,000 loan.  Then again, I’m not an expert in mortgage loans and relying on marketing quotes on websites is probably not the best thing except to set a ballpark range.  I’m going to assume we’d pay around 3% which means $9,000 on that $300,000 loan I mentioned earlier.  Break even would be two years out, and after that we’d be saving $4,500 per year on payments.   To get something more accurate, I’d have to talk to lenders which I can’t quite do in the middle of the weekend.

But what about if we aimed at the shorter payoff period of a 15-year fixed rate loan?  From a quick look at BankRate.com, the current average 15-year rate is 5.25% versus a 30-year of 5.54% (last week it was 5.40% vs. 5.60%.)  Let’s assume they differ by 0.25% on average and thus if the 30-year drops to 4.5% by the government’s action, then the 15-year will be at around 4.25%.  Using a simple mortgage calculator, our $300,000 loan amount would now require a $2,256.84 monthly payment, which is actually $360 more per month than the amount before refinancing the current 30-year loan.   I don’t think our budget plan can take that hit right now.   Even if the 15-year rate was as low as 3.00%, the payment would still go up by $175/month.  I think we can rule that out from consideration.

What about the last idea of taking some equity out?  While it is probably the cheapest source of money we have access to, we don’t yet have anything to do with it that wouldn’t be exceptionally high risk due to our lack of experience in more effective ways to use it — either effective trading, short term investing, rental properties, etc.  Our risk averseness will prevent us from pursuing this anytime soon.

In conclusion, the only really interesting option to me right now, due to feasibility reasons, is refinancing to save money on the payments.  But even there, more effort is required to truely analayze and understand when it’s worth it to pull the trigger.  I don’t think we’ll do that until we notice the rates actually coming close to a rate drop by 2%.  There just isn’t much else to prepare in advance for that sort of action.   On the other hand, we will be constantly learning about other ways to generate income (most likely options trading) and if we feel more confident we might want to refinance solely to pull out equity as long as the rate isn’t higher than our current one.

Tags: Loans

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