Should I refinance?

If you are trying to weigh the costs to decide whether refinancing your home makes sense for you, then this is the post for you.  Often times the daunting costs of refinancing can make you leery, and you’ll wonder, “Is this worth it?”  Let’s do a break-even analysis of home mortgage refinancing.

Getting a lower interest rate can save you thousands, or even tens of thousands of dollars.  For reference, here is the amount of interest you pay over the life of a 15 year loan borrowing $100,000 with varying interest rates.

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As another helpful note, please keep in mind that the shorter the term of the loan, the lower the interest rate.  Don’t blow by that so quickly.  If you choose a 5, 10, or 15 year mortgage, it will get you a better rate than a 30 year mortgage.  Who the heck wants to pay on a house for 30 years anyway?

Before you begin thinking about a refinance as a way to get a lower payment, please pause.  If someone is offering you a lower payment, two things are happening.  You are paying less toward the principal, and you’re probably starting the clock all over again on the mortgage.  Lower payments keep you in debt longer.  This may have a short term benefit of releasing pressure on the budget, but long term, it’s a bad decision.

Now we can set the table on the break-even analysis.  As with any good decision, you will need to gather as much good information as you can.

Ask yourself these questions, and write down the answers for your break-even formula.

  • What is your current interest rate?
  • What is the new rate you are being offered?
  • Do you have PMI? (And if so, how much equity do you have?)
  • How long do you plan to stay in the home?
  • What is your current balance?
  • What are the closing costs?

Let’s boil down your numbers.  Subtract your new rate from your current rate.  This will be the margin to calculate your savings.  Next, take your loan balance.  Multiply this margin by your balance.  Here’s an example.

Scenario:

  • Currently have a 5% loan with $100,000 borrowed
  • Being offered a 3% loan with $100,000 borrowed
  • Closing Costs are $4,500

Your margin between the interest rate is 2% (5% minus 3%), so this interest margin is where you save money (over time).  The closing costs are $4,500.  So with some back-of-the-envelope math, you can calculate roughly $2,000 in interest saved per year (slightly less as the loan amortizes).  So it will take about 2.25 years (or 2 years, 3 months) to break even on this transaction.  I arrived at this number by dividing $4,500 / $2,000 = 2.25.  After you know it will take 2.25 years to recover the costs, you can compare this with how long you expect to live in the home.  If it’s close – don’t waste your time and energy.  If you plan to stay put for a decade, then do it!  If you are getting ready to move in the next year or two, forget about it.

Another aspect to consider is if you have PMI on your current mortgage.  If you do, consider it “interest” in your calculation.  Some loans have PMI disappear at 80%, others 78%, and others have PMI for the life of the loan.  Consult your loan documents or ask your lender when (or if) your PMI is scheduled to go away to help you make this decision.  If you can refinance with 20% equity in the home, then you have added savings, and likely a much quicker break-even time period!

Lastly, maybe things are tight in your home, and maybe you’re still plowing through consumer and student debt.  If this is the case, the lender may offer you to roll up the closing costs into the loan balance.  If you are fighting through this situation, it may be okay to roll those into the loan.  However, if you’re out of debt, pay the closing costs with cash.  It doesn’t make sense to dig a deeper hole if you can afford the closing costs.  Neither decision is bad, but make the best decision you can with the circumstances you are in.

If you want to play with mortgage amortization schedules yourself, please visit the Resources page.  You can learn about your current mortgage and also see what refinancing can do for you.

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