The broad market has been under extreme pressure over the past year, which has led to the Federal Reserve board and the Federal Open Market Committee deciding to lower the target federal funds rate. There are many different tools that are affected by the rising and falling of the target federal funds rate.
Typically, one outcome of low target rates is lending institutions like banks lowering interest rates for mortgages. Most of the time when mortgage rates drop the headlines are quick to flash the news and lenders campaign competitive rates with calls, emails, and other various tactics. Marketing for mortgage refinancing has persisted in 2020 with the target federal funds rate staying steady at 0.00% - 0.25%. For most homeowners this falls on deaf ears because trying to determine the best plan of action for a home, typically ones largest outstanding debt, can be a daunting task. Being able to quantify long term savings and gather facts that support the decision to refinance can ease the debt burden and tremendously increase the likelihood of success in a financial plan.
To begin, overview your current loan situation by identifying monthly payment, interest rate, and length of the loan remaining. A crucial next step that is a large factor in whether or not to refinance is determining how long you plan to retain your home. If you are in a starter home and plan to move in the next 24 months it might not make sense to refinance, but the current interest environment could still warrant a revised rate for short-term and long-term borrowers alike. The reason for shorter term homeowners to not pull the trigger can be found in the fees associated with refinancing. Lenders, title, document preparation, and title policy are some of the various fees to be accounted for when preparing for a refinance. As these costs can make or break the effectiveness of a refinance, it can be helpful to consider more than one option for a title company and lending firm. These fees also require cash up front, which is the key variable to determine a breakeven timeframe for your current mortgage versus refinancing. Once all costs are accounted for you can compute the amount of months until breakeven.
Old Monthly Payment – New Monthly Payment = X
Out of Pocket Costs / X = Number of Months Until ‘Breakeven’
Using the above formula, you can determine if refinancing makes financial sense by comparing the number of months until savings replenish the initial out of pocket expenses, or ‘breakeven’, to your specific time horizon. For example, if the old monthly payment was $2,000, new monthly payment is $1,750, out of pocket costs total $3,500, and the borrower plans to reside in the home for two years, then the numbers setup as follows:
$2,000 – $1,750 = $250
$3,500 / $250 = 14 months under breakeven
In this scenario the refinance would be worthwhile as the breakeven is 14 months, and every month thereafter the borrower would save $250.
Every month after the breakeven in a refinance you are spending less money than previously planned. With the historically low rates it is more than likely an advantageous time to ultimately free up more money in the long term. On a small scale, a homeowner that can save $50 per month from a new mortgage rate would end up saving $18,000 over the life of a new 30 year loan. From a financial planning standpoint, using the tool of properly refinancing a mortgage can have significant long term wealth and lifestyle enrichment. Another item to take into consideration is a credit check, which could have a short-term negative impact on your credit score. If not feasible to complete the process right now, it would be beneficial to keep a keen eye on trends in the coming months as the Federal Reserve board has fully committed to combating the economic impact felt from the coronavirus. The monetary policy commitment might keep pressure on rates for an extended period. While it can be time intensive and sometimes costly, the end result of refinancing should increase the probability of meeting financial goals that lead to financial freedom.
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