Americans owe about $19.3 trillion in mortgage debt, 69% of which are tied to 1- to 4-family residential properties. It’s the single largest source of debt in the US, at least 20 times more than credit card debt. Millions of mortgage loans are originated and refinanced every year, making it a thriving and almost evergreen industry.
However, just like any other market, there are right and wrong times to enter the mortgage market, regardless of whether you are taking out a mortgage for your primary home/investment property or refinancing your mortgage. Identifying the right time to refinance a mortgage can offer you substantial financial benefits, and choosing the wrong time to refinance can have significant repercussions.
It’s important to understand that the right time to refinance a mortgage and the right time to refinance your mortgage are two different concepts. One is almost entirely dependent upon the interest rate, but the right time for you will depend upon various factors.
From the perspective of interest rates, the best time to refinance your mortgage is when the new interest rate you can get is lower than the interest rate you are currently paying. Experts suggest that there should at least be a difference of 0.75%. For example, if you have a fixed mortgage rate of 5%, refinancing at 4.5% might not be ideal. You should look (or wait) for it to fall below 4.25% or lower.
When interest rates are low, more people take out new mortgages or refinance their existing mortgages to take advantage of lower rates. An example was the year 2021, when mortgages of $4.51 trillion were originated, the highest number in 20 years, thanks to the historically low-interest rates. The refinancing followed the same pattern, and $1.6 trillion in refinancing loans were underwritten in just the first half of 2021.
Credit score can play a significant role in the mortgage rates you get. The Annual Percentage Rate (APR) may differ by as much as 1.5% between borrowers with the best credit scores (760-850) and borrowers with the lower scores (below 640), although the spread may be smaller when the interest rates are low.
So if your credit score improved (substantially) from when your original mortgage was issued, refinancing it may help you get a better rate, assuming there is no substantial difference in the underlying interest rates. If there is, the benefit you get from improving your credit score will either be compounded or neutralized. Let’s say your credit score has improved enough that you can now get a mortgage rate of 1.2% lower than your original rate.
In the meantime, however, the underlying interest rates have increased by 2%. If you refinance now, you will actually be in a deficit. However, if the interest rates have gone down while your credit score went up, you may be able to refinance at a much more attractive rate than either your credit score improvement or lower interest rates could have gotten you individually.
How Far You Are In Your Amortization Period
Another time factor to consider when refinancing your loan is your amortization period. Whether you have a fixed or variable-rate mortgage, most of your early payments go towards paying off the interest, and as you go deeper into the amortization period, the balance shifts. Towards the end, most of your monthly mortgage payments go towards the principal balance and the remaining towards your interest.
So if you are planning on refinancing when you have paid off most of your original interest and relatively little of your principal amount, it might not be an efficient move. Refinancing will get you a new mortgage, and you will start the cycle again, i.e., paying off the interest rate. In contrast, if you refinance early, for example, when you are three to five years in a 30-year fixed-rate mortgage, the difference you will get from low-interest rates (and/or better credit score) may more than make up for the additional interest you will pay.
Private Mortgage Insurance (PMI)
If you take out a mortgage with less than 20% in terms of the down payment, you might need to pay Private Mortgage Insurance (PMI) until you have built 20% or more equity in the home. Once you reach this level, you can use refinancing to get rid of PMI, reducing your monthly mortgage payments by a decent margin. However, refinancing may not be the only recourse to remove PMI, and you may be able to eliminate PMI once you have 20% or more equity in your home (through mortgage payments and value appreciation) by requesting a cancellation.
The right time to refinance your mortgage doesn’t always depend upon interest rates, credit score, amortization period, and how much equity you have built. It may also depend upon your needs, financial situation, and financial choices. This includes:
- You may refinance your mortgage if you want to reduce the loan term from 30 years to 10 or 15 years. It may increase the monthly payments significantly (even if you refinance at a lower rate), but it will also allow you to be debt-free much sooner.
- When you want to switch from a variable rate mortgage to a fixed rate mortgage or from a fixed to variable rate mortgage, a variable rate allows you to benefit from lower interest rates, while fixed rates offer more predictability and protect you if interest rates go up. Refinancing can help you switch between the two and benefit from interest rate changes, but be sure to take into account other factors and refinancing costs into account when making this decision.
- Refinancing is a good option when you want to take equity out of your home. Cash-out refinancing gives you a good alternative to HELOC, especially if you need a lump sum amount at once. You may use it to consolidate debt or meet an expense that would have otherwise required you to take on a different debt. If you opt for cash-out refinancing when interest rates are significantly lower, you can also benefit from lower monthly payments (though it depends upon the amortization period and other factors).
The right time to refinance your mortgage depends upon multiple factors. Ideally, the perfect time to refinance is when multiple positive factors align, i.e., interest rates are low, you have improved your credit score, and you are only a few years into your amortization period. This way, refinancing may significantly lower the overall cost of your mortgage.
In some cases, the right time might have more to do with your pressing needs than market conditions beyond your control. If you have accumulated substantial credit card debt with a 20% interest rate, refinancing your mortgage at a higher rate to consolidate your debt might be the smarter financial move.