How Much Should Rates Drop Before Refinancing?

When we talk to homeowners, they always ask the million-dollar question: How long should I wait to make the cost to refinance a mortgage worthwhile?

A 2% rate drop seems like a no-brainer, but what about a 1% drop? Perhaps even a 0.5% or .25% drop, as we’re more accustomed to seeing in the current rate climate? 

The answer isn’t as straightforward as you might think—it’s not one-size-fits-all. Your individual circumstances play a significant role, and we’ll dissect that in this guide.

Whether you’re grappling with a $100,000 or $1,000,000 mortgage, our step-by-step approach will provide the insights you need.

Rate drops vs. the cost of refinancing

Let’s tackle the elephant in the room: What rate drop should prompt you to refinance your mortgage? Unfortunately, no matter what anyone online tries to tell you, there’s no universal answer.

Here’s why:

• Fixed costs: These are costs associated with refinancing that remain constant, regardless of your loan amount. They include the appraisal, title, and credit report fees. These costs make small loans less viable for refinancing.

To illustrate this point, let’s delve into two examples:

1. $100K Mortgage: Refinancing this loan might incur costs of around $4,000. If your monthly savings due to refinancing are only $40, the math doesn’t work in your favor. You’d need 100 months (over eight years) just to break even. In this scenario, refinancing doesn’t make financial sense.
2. $700K Mortgage: In this case, even a minor rate drop of 0.25% would save you over $100 monthly. Although you’ll still have the same fixed costs as the smaller loan, the potential savings are significantly higher. This means you can recoup your initial outlay faster, making refinancing a logical choice.

The larger your loan, the more these fixed costs dilute, making even a small rate drop potentially beneficial.

Payment reduction by rate decrease and loan amount

To help you visualize the savings-cost ratio, you must calculate further; we’ve put together these charts to show you some examples of how it might work out.

Now, if we look at these same examples in terms of the years it will take to recoup the refinance costs—otherwise known as the break-even point—it looks like this:

*All closing costs mentioned are for example purposes only. Your costs could be higher or lower.

As these tables show, the bigger your current loan, the more it makes financial sense to refinance—even with a fractional drop in interest rates.

If the amount you’ve paid for your home is close to the national median—currently hovering around the $435,000 level—refinancing your mortgage means you could hit the break-even point in less than three years with only a half-a percentage drop in rates.

At the national average home price, it would take just three years to break even on refinance costs with a 0.50% rate reduction.

After that point, it’s all savings.

Plus, the higher your mortgage amount, the less time you have to wait—and the more savings you’ll have going forward.

And it may not be merely a drop in interest rates that motivates you to refinance your mortgage. As we’ll show you next, there are several other reasons you might consider refinancing your mortgage beyond the potential savings.

Are there other reasons to refinance besides a rate drop?

Besides a drop in interest rates, there are various compelling reasons to consider refinancing a mortgage.

Let’s explore some common motivations behind this financial decision.

Exchange loan terms

Refinancing allows you to change your loan terms, offering flexibility and potential benefits.

For instance, you can transition from a 30-year mortgage to a 15-year one, accelerating your mortgage payoff and achieving financial goals sooner. You could also change a 15-year to a 30-year to reduce your monthly payment.

Consolidate debt

Refinancing offers a practical solution for consolidating debt.

By tapping into your home’s equity, you can pay off high-interest debts, such as credit cards or personal loans, potentially resulting in lower payments overall.

Access home equity

By refinancing, you have the opportunity to access your home’s equity. This means you can extract cash from your home’s equity and allocate it towards bills, renovations, or whatever you choose.

This financial strategy enables you to leverage the value of your property for various purposes, enhancing your financial flexibility and goals.

Pay off a mortgage faster

Accelerate your mortgage repayment. This will reduce the amount you spend on interest payments and allow you to save money over the entire loan duration.

Get rid of private mortgage insurance (PMI)

Refinancing your home can be a smart move to eliminate the requirement of private mortgage insurance once you’ve accumulated sufficient equity. It’s a strategic way to optimize your finances and enhance long-term savings.

Change loan type

By refinancing, you can switch your loan type, allowing for greater flexibility and improved financial stability.

For instance, you can transition from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage, giving you the confidence of a consistent, reliable interest rate.

Check the cost and benefit of a refinance

Refinancing isn’t a choice that can apply to every homeowner and mortgage holder. It’s a nuanced decision influenced by:

• Your loan size: Larger loans can justify refinancing even with a small rate drop.
• Fixed costs: Appraisal, title, and credit report fees are constants that dilute more with bigger loans.
• Potential savings: Calculate your break-even point. If you’re not saving money in the long run, it’s not worth it.

Remember, while a 2% rate drop is often touted as the ‘golden rule’ for refinancing, it does not apply to everyone.

Assess your circumstances, run the numbers, and make an informed decision. Refinancing can be a powerful tool, but only when wielded correctly.