How Much Should Rates Drop Before Refinancing?
5 minute read
·
August 30, 2023

Share

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 1%? Perhaps even a 0.5% drop? 

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 that’s what we’re going to dissect 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.

Get started on your refinance.

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, there’s no universal answer—no matter what anyone online tries to tell you.

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

Loan amountClosing costs0.5% drop payment reduction1% drop payment reduction2% drop payment reduction
$100,000$4,000$41$81$158
$250,000$4,500$103$203$396
$375,000$5,000$154$305$594
$500,000$7,000$205$406$792
$750,000$10,000$308$609$1,188
$1,000,000$12,000$411$812$1,583

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:

Loan amountClosing costs*0.5% drop break-even years1% drop break-even years2% drop break-even years
$100,000$4,0008.14.12.1
$250,000$4,5003.71.80.9
$375,000$5,0002.71.40.7
$500,000$7,0002.81.40.7
$750,000$10,0002.71.40.7
$1,000,000$12,0002.41.20.6

*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 is, 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—which is currently hovering around the $440,000 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 3 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.

Start saving with a refinance.

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 presents the chance 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 the equity of your home, 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 the equity in your home. This means you can extract some cash from your home’s equity and allocate it towards bills or renovations. 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 the repayment of your mortgage. This will not only reduce the amount you spend on interest payments but also 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 open up the opportunity to switch your loan type, allowing for greater flexibility and improved financial stability.

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

Check the cost/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’s not applicable to everyone.

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

Get your refinance quote here.

Our advise is based on experience in the mortgage industry and we are dedicated to helping you achieve your goal of owning a home. We may receive compensation from partner banks when you view mortgage rates listed on our website.

Share
Share on LinkedIn
Email this Article
Print this Article


More on Refinance Optimization Tips from MyPerfectMortgage