Don't Overlook This Crucial Factor in Mortgage Refinancing

For weeks on end, prospective home buyers and homeowners alike were bemoaning the fact that mortgages were so expensive to sign. But in recent weeks, mortgage lenders have been lowering their rates. And as of this writing, the average 30-year mortgage rate is sitting at 6.61%, according to Freddie Mac.

Now if you're someone who signed your mortgage back in 2021, a rate of 6.61% probably isn't much to write home about. But in late October of 2023, the average 30-year mortgage rate was 7.79%. So if you locked in a mortgage at that level a few months ago, you may be tempted to refinance your loan now that rates are lower.

In fact, generally speaking, it can make sense to refinance once you're able to shave about 1% or more off of your mortgage's current rate. But if refinancing is something you're looking into, be sure to account for one key factor.

Make sure you'll be able to recoup your closing costs

When you sign a mortgage -- whether it's an original purchase mortgage or a refinance -- you're charged closing costs by your lender. Those costs are a collection of fees that are incurred in the process of putting a loan in place.

Closing costs on a mortgage commonly amount to 2% to 5% of the amount you're borrowing. Because of this, it's important to make sure that you intend to stay in your home long enough to recoup those fees and benefit financially.

Let's say you recently signed a 30-year, $200,000 mortgage at 7.79%. That would leave you with a monthly payment of $1,438 for principal and interest.

Getting a new 30-year loan at 6.61% would mean paying just $1,279 a month in principal and interest on a $200,000 balance (and yes, if you've had your mortgage for a few months, your balance may be slightly lower, but probably not by much, since early mortgage payments mostly go toward interest, not principal). So that's a potential monthly savings of $159.

However, let's say you're charged 4% closing costs on a $200,000 loan balance. That means you're shelling out $8,000 to put your new loan in place. When we divide $8,000 by $159, we get 50 (more or less), which means that refinancing will only make sense if you intend to stay in your home for more than four years and change.

If you think you've found your forever home, then yes, it might take you 50 months to break even on your closing costs, but from there, it's all savings. However, if you think you might move in three years, then you could end up losing money by refinancing.

Don't just chase a lower rate

It can be very tempting to chase a lower interest rate on your mortgage, especially if you happened to sign your loan at a time when rates were notably high. But before you rush into a refinance, calculate your break-even point. That's one of the best ways to determine whether a mortgage refinance actually makes sense or not.