Mortgage rates continue to fall with the 30 year term loan dipping to 3.50% and the 15 year term loan near 2.75%. This continued decline likely has many homeowners on the edge of their seats ready to refinance or apply for a mortgage now. But, it is important to understand what are the causes for the falling interest rates and if you are the right candidate for refinancing.
Why are mortgage rates continuing to fall?
There are many reasons but let’s focus on two primary causes. The Federal Reserve bank has stated that they will target short-term interest rates at zero percent through 2014. Generally speaking, there is a 3% spread between mortgage rates and short-term interest rates which explains part of the reason why mortgage rates are low. But, there is another more current factor contributing to lower rates.
Should I refinance?
From purely an macro-economic standpoint, it appears that rates will continue to fall as the European debt crisis is likely to worsen and the Federal Reserve has no immediately plans to raise the federal funds rate. But, we may be close to a floor so the upside is likely limited for waiting to refinance in six months as opposed to doing it now.
The more important factor to consider is your own personal finances. Specifically, your ability to comfortably pay off your mortgage as well as pay for the upfront costs associated with refinancing. The closing costs alone can range any where from 3 to 5% of the entire loan balance. So, a mortgage holder with a $350,000 loan balance would have to pay $14,000 or more just to cover the closing costs. That is a significant amount of cash that many homeowners simply can’t afford.
Should I switch to a short-term loan such as a 15 year mortgage?
If we compare a 15 year mortgage to a 30 year, the interest savings for the 15 year can be significant at 75 basis points per year. But, a short-term loan requires the borrower to pay higher monthly principal payments. For instance, a borrower with a $750,000 30 year mortgage at 3.5%, will need to make monthly payments of $3,367 versus $5,099 for the same size loan with a 15 year maturity at 2.75%. So, while the interest savings could be significant, the total payments are $1,700 more for the borrower with a 15 year term. But, what about the fact that the borrower will pay much less interest over the life of the loan and be done quicker? That’s true, the 30 year borrower would pay $462,420 in interest versus $166,139 for the 15 year borrower if neither borrower paid off the loans prior to maturity.
What about the fact that a home is not a very liquid asset?
The housing market is still struggling and thus homes are less liquid than in prior decades. This supports the argument for obtaining a 30 year loan because it will provide the borrower with more liquidity. Specifically, with a 15 year loan the borrower is putting more equity into an asset that lacks liquidity. The borrower could theoretically use that extra cash for other purposes such as 401K contributions and if the market turns they can always dump more equity into their home and payoff the 30 year quicker.
Watch out for prepayment penalties
If you do decide to apply for a mortgage or refinance, make sure you ask about prepayment penalties. Lenders earn the greatest profits on the interest they receive from borrowers and thus may penalize borrowers for paying off their mortgage prior to maturity.
What should I do?
You need to consider all of your options for refinancing or applying for a mortgage. While rates are at record lows, refinancing isn’t for everyone. If you have credit card debt, in most cases, it makes more economic sense to pay that off first. Financial flexibility is one of the most important factors to consider with this decision. The last thing you want to do is stretch yourself too thin and not be able to meet your mortgage obligations.
More Mortgage Questions? Browse Answers or get mortgage refinancing advice online.
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