An existing loan exists on specific terms, including interest rates, payment schedules, and other contractual agreements. Many times, people have asked if it is wise to refinance in a period when interest rates become low.
There is no one size fits all answer to that question, and the best direction to go is highly dependent on each person’s financial position and the position of the debt or mortgage.
What is Refinancing?
Refinancing is the process of revising, modifying or replacing the terms under which an existing credit agreement operates. People may decide to refinance for different reasons.
Usually, a loan or a mortgage is taken under a specific contract binding on the borrower. When a borrower feels he can no longer fulfill a credit agreement’s obligations, he may then push for a refinancing.
Borrowers also opt for refinancing when interest-rates change substantially. When interest rates become low, borrowers may attempt to negotiate a new credit agreement with the lender to optimize saving, renegotiate payment schedule, reduce payments over the loan tenure, lower the fixed interest rate upon which payments are made, or switch from an FRM—Fixed-Rate Mortgage to an ARM—Adjustable-rate mortgage.
Borrowers may also make refinancing decision if their credit profile has substantially improved, if they want to make changes to their long-term financial plans, or if they want to consolidate their debts. Consolidation is a process where borrowers consolidate all their loans under a single loan with a lower interest rate.
Should I Refinance my Mortgage if Interest Rates Drop?
When refinancing was introduced into the mortgage and other loan obligations, there was a frenzy. Everyone would push for refinancing once the interest rate is reduced; however, refinancing depends on your unique financial position.
The purpose of refinancing is to put yourself in a better financial situation; therefore, if you opt for one, you must be assured that you will be saving a substantial amount of money in the long-run. Before deciding on refinancing, you should consider the following:
Difference in Rates
There are times that refinancing will not matter even if interest rates drop. The percentage of the drop is the crucial factor in refinancing.
If the interest rate drops to only about 1%, refinancing may not yield substantial savings if you owe the principal amount of $100,000. 1% interest rate on $100,000 is $1,000. Spread the figure ($1,000) over the loan tenure, say, seven years.
However, if there is a 1% difference in interest rates on a $1,000,000 loan or mortgage, refinancing should save you $10,000 in gross.
Closing Cost
Even if the interest rate yields a substantially stable gross amount, you must consider the closing costs of refinancing. Refinancing is a package; that is, it does not come free; hence, you must think how much you will be paying and if it will still make a difference in the amount you save.
If you wish to sell your home in a few years, refinancing may cause financial retrogression as you may barely break even, let alone make a profit from refinancing.
You Can Refinance your Loan into a Shorter Term.
If you have a mortgage with ten years left on it and refinance it into a new 20-year mortgage contract, you may not break even. You will likely lose money over the long-run.
This is because even with a lower interest rate, the extended loan tenure means you will be paying interest for a much longer time than the initial agreement.
However, if you refinance your existing mortgage from 10-year tenure to 5-year tenure, you will save up substantial money from the reduced interest rate, and you will clear your debts quickly.
