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Do Today’s Record-Low Rates Make Refinancing a Winning Strategy?

Mark Fitzpatrick
6 min read
Do Today’s Record-Low Rates Make Refinancing a Winning Strategy?

Most people have heard the old rule of thumb that it takes a 1% drop in your interest rate before a mortgage refinance is the smart play. Countless personal finance experts have passed on this rule over the years. This advice, however, is too simplistic. Maybe it caught on because it’s easy to remember. Or maybe it’s just so simple that people tend to pass it on as sage advice. It’s not.

Yes, today’s record-low rates mean that you very well might enjoy a 1% interest rate drop and a lower monthly mortgage payment. But even if you don’t, refinancing might make sense.

In fact, there are times when a refinance makes perfect sense even if the rate is going up, not down. For example, if someone has an adjustable-rate mortgage that carries long-term risk, it might make sense to accept a higher rate on a new loan. Some people refinance from a 15-year loan to a 30-year mortgage term due to changes in income and the resulting cash flow crunch. Other people might need to refinance due to a divorce situation or to get a non-occupant co-borrower off the mortgage. You get the picture.

How does refinancing work?

Refinancing a mortgage means replacing your old mortgage with a new one—including a different balance and possibly a different interest rate or loan term. Refinances are often used when the market has lower interest rates or when homeowners want to lower their monthly payments.

Some homeowners utilize a cash-out refinance to take advantage of their home equity (or the home’s value compared to what you owe) for renovations and other major expenses.

The process is similar to applying for your first mortgage loan. Be sure to shop around at different financial institutions and compare offers to your current loan. Lenders will look at your credit score, loan balance, and debt. There may be a title search and an appraisal. You might pay 2%-5% of your mortgage balance when refinancing, depending on closing costs and other necessary fees. Keep reading to run the numbers and decide if refinancing your mortgage is best for you.


More on conventional mortgages from BiggerPockets


Should I refinance my mortgage?

Changes in income or a personal matter, like divorce, are legitimate reasons to accept a mortgage with a higher interest rate than the current mortgage carries. But what if you are trying to assess whether or not to refinance based purely on the economic benefit derived from a lower rate? Here are the questions to ask yourself to make a sound choice:

  • What are my personal plans for the property?
  • How does the current rate on my mortgage compare to the proposed new rate?
  • Am I following the BRRRR strategy?
  • Will I be able to pull out equity?
  • Do I need cash to improve my property or pay off debt?

Let’s start from the top.

Personal plans for the property

How long are you going to keep the property? Do you have plans to sell it within a few years or less? Will there be a reason to do another refinance during a similar time period? If the answer to either of these questions is yes, it may make more sense to hold on to the original mortgage or to consider an adjustable-rate mortgage, which can result in a much lower rate than a fixed rate does.

If you plan to dump the property within a year, you will have a hard time recouping any closing costs you incurred with the refinanced mortgage. However, if you are not sure, you may want to hedge your bets by planning for the long term just in case.

Current rate on your mortgage vs. proposed new rate

The rates and terms banks offer change over time. If you have a bad loan, particularly if it’s fixed at a higher rate, it’s something you should definitely consider refinancing out of.

The rule of thumb is to refinance if you can lower your rate by one full percentage point. That being said, Investopedia states that experts vary on their advice between 1% and 2%. The longer you plan to hold the property, the more it makes sense to accept a smaller reduction in the rate. So if you only think you’re going to hold the property for another year or two, it’s not long enough to refinance for a 1% gain. On the other hand, it usually would make sense if you plan to hold it for five-plus years.

The figures below will help you determine how much money you can potentially save through a refinance to a lower rate. Forget about that 1% figure for now.

The amount of the new mortgage

You will need this number to calculate the monthly savings in interest from the switch to a lower rate. Here is an easy formula:

(Old Rate – New Rate) /12 x Amount Owed / 100 = Monthly Savings

Here is an example. Let’s say you are refinancing a $250,000 mortgage from 5.5% to 4.75%.

5.5 – 4.75 = .75

.75 / 12 = .0625

.0625 x $250,000 = 15,625

15,625 / 100 = 156.25

Your monthly interest savings would be $156.25 on this loan.

The total net closing costs

When you have the total net closing costs, you can then compare the cost of refinancing to the lower monthly payments from the new loan and get an idea of how long it would take to pay off the costs of the loan.

To see what the loan will cost you, you may want to check out a closing cost calculator such as this one.

Otherwise, you can also run the numbers by hand.

Say you have a $200,000 loan at 5% interest (amortized over 30 years) costs $1,074/month. At 4%, it costs $955. So each month, you would save $119. Let’s say your expenses look like this:

  • Appraisal: $450
  • Recording, origination fees, and title fees: $500
  • Loan fees: $2,000

In this case, the closing costs of the loan would be $2,950. With $119 a month in savings, it would take 25 months to break even. That being said, it’s not worth the time and effort to refinance a property if you’re only going to break even. In the above example, you’d want to hold for at least four more years before pulling the trigger on a refinance.

It’s also important to remember that interest rates aren’t the only thing. There are many other factors to think about with a loan, including:

  • Fixed-rate or adjustable. It may be better to refinance an adjustable loan into a fixed one to reduce risk
  • Amortization. A 15-year amortization will require substantially higher payments even at the same interest rate as a 30-year amortization.
  • Term. As noted above, you may have to refinance to avoid a balloon payment.
  • Loan fees. If too high, the fees could make even an attractive interest rate unaffordable.

Refinancing the mortgage as part of a strategy

Knowing how mortgage refinancing works is a key part of the BRRRR strategy. In fact, you’ll notice it’s the third R (buy, rehab, rent, refinance, repeat) in the acronym. Once you have rehabbed and rented the property and it has “seasoned” (the amount of time a bank requires before they will lend on the appraised value instead of your cost into the property), it’s time to refinance. Do this either to replace your high-interest private loan with a long-term loan or pull out the cash you put in the property to begin with.

Refinancing may also be a component of a different strategy as well. And if it’s part of the strategy you are using, you should obviously refinance when that strategy calls for it. Sometimes, circumstances may force this upon you. Say a partner demands it, or the loan is nearing its balloon and is about to be called due. Almost every loan will have a term, usually five years. Most banks will renew the loan at that time, but sometimes they will not. And national lenders that specialize in investment properties, such as A10 Capital, usually have a hard balloon date when you have to pay the loan off. In these times, unless you intend to sell, you would need to refinance.


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Pulling out equity or cashing in

One of the most important ways that real estate creates wealth is as properties appreciate and you pay down principal, your equity starts to grow exponentially. That being said, you can’t buy much with equity. To spend equity, you need to pull it out first. And so one great way to grow your real estate portfolio is to refinance properties you already own and use the equity you pull out as capital to purchase new assets.

The question you have to ask yourself is, “Will I make a good enough return investing this money to make up for the increased mortgage payments of a higher loan?” This is something that you would need to run some numbers on.

Another important reason to refinance out the equity in your property is debt consolidation. Mortgages are much cheaper than credit cards and many other types of debt. If you have high-interest debts, it makes a lot more sense to pay them off with a lower interest mortgage.

Some people might also refinance to use the extra cash to improve the property or pay off other debts. That being said, refinancing your properties to buy stuff or consumer goods isn’t a good idea. This type of borrowing gets a lot of people into trouble. Stuff, in the end, is just stuff. You really don’t need that much of it.

But real estate investors do need refinancing. And if you know when to use it, it can help you grow your real estate investment portfolio immensely.

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.