You’ve probably heard it a hundred times: “Mortgage rates are so low right now you have to refinance!”. But is it true? Does refinancing make sense for you?
Everyone’s circumstances are different. Loan balances, interest rates, remaining months on the loan – they all vary depending on each individual situation. However, there is one thing that is, and always will be, the same for everyone: math. And it’s only after you “do the math” that you should make the decision whether or not to refinance.
Timing isn’t everything, but it’s extremely important.
Many homeowners adhere to the general rule that the best time to refinance is when mortgage interest rates drop two or more percent. Well, what about when it drops less than two percent? Can you still save money?
Take a look…
On a 30-year, $100,000 loan with a 7% interest rate, the total interest paid will be $139,508. Drop that interest rate two percentage points to 5% and the total interest paid falls to $93,255. That 2% rate decrease saved you $46,253.
Now, take that same 30-year, $100,000 loan at 7% interest and drop the rate by just 1.5% and the total interest paid falls to $104,404 – a savings of $35,104. To most of us that’s not exactly small change, so the “rule” of waiting for rates to drop 2% or more might not work for everyone. A decrease of 1.5% or even 1% could have a beneficial impact on your finances.
When you think about timing, it’s also important to consider how long you plan to remain in your home. If you think you’ll be staying a long time, refinancing at less than 2% can still provide you with profit since you’ll have many years to regain the money you spent on the new mortgage loan.
Costs – Refinancing Isn’t Free
Something to note about the examples above (and real-life refinancing situations) is that the savings noted are “gross”, not “net”. There’s more math in the equation than meets the eye.
- For example: take into account the number of months you have remaining on your existing mortgage versus the number of months you’ll be paying off your refinanced mortgage. Even if you get a lower mortgage rate, extending the length of time to pay it off could negate any savings.
- A loan origination fee is typically charged by lenders to analyze, prepare and properly submit your loan. This fee of .5% to 2% of your loan amount will eat into the money you’re expecting to save on your refinanced loan.
- Additional fees might include closing costs, such as: credit fees, appraisal fees, points insurance, taxes, escrow and title fees. Another few bites into your savings. This refinancing calculator can help you figure some of these numbers out.
Once you add up the costs, take into consideration another well known “rule of thumb”: one should refinance when interest savings will cover the loan costs in two years or less. Will this be true for you? Just something else to think about when making that “should I or shouldn’t I?” refinance decision.
The Final Equation
Okay, so you’ve done your research, determined whether or not to cash some equity out of your home, and now it’s time to make the decision: refinance or not. You can use the simple formula below to calculate how long it should take to amortize the refinance costs before you “breakeven” and your savings can commence.
REFINANCE COSTS/MONTHLY SAVINGS WITH NEW MORTGAGE PAYMENT = NUMBER OF MONTHS BEFORE BREAKEVEN POINT
So, for example, if your refinance costs are $5,000 and you’re saving $350 per month with your new mortgage payment, it will take about 14 months to break even. Are you planning to stay in your home for another 14 months? If yes, refinancing could make sense. If no, refinancing might not be the best way to go.
NOTE: Like the majority of homeowners, you most likely deduct mortgage interest on your income tax. Before making the final decision whether or not to refinance, talk to your accountant and see how lowering your interest rate might affect your tax situation. That’s an important detail that could possibly sway you one way or the other.
Of course, FICO offers a few great resources to help you come to a well-informed conclusion on the issue. Check out their Refinancing Educator and then head to the “Am I better off refinancing” calculator to crunch some numbers.
If you’re getting lost in all the terminology, we’ve got you covered there, too. Below is a glossary of common terms used in the refinancing process. It’s a good idea to have these memorized before you start the process (or even before you start researching).
List of terms used in mortgage refinancing:
Adjustable-Rate Mortgage Also called an ARM, this type of mortgage has an interest rate for a set period of time. During this period the interest rate is lower. Once the initial period ends, the rate will adjust, based on an index and will continue to adjust at set intervals.
Annual Percentage Rate This is either “fixed” or “adjustable” and is the rate of interest that will be paid back to the mortgage lender.
Amortization This is the schedule for how the loan is intended to be repaid and typically calculates the monthly breakdown of how much interest you pay and how much is paid on the amount borrowed.
Closing Costs These are expenses/costs paid by the homeowner/home buyer during the mortgage process. Closing costs can range from attorney and recording fees to points, escrow and title fees.
Equity This is the difference between the value of your home and the amount of your mortgage loan. As the value of your home increases and the amount of the loan decreases, your equity will grow.
Fixed-Rate Mortgage This type of mortgage has a set interest rate and loan term, typically ranging from 10 to 40 years.
Origination Fee This fee is paid by borrowers to lenders and generally includes an application fee, appraisal fee, and fees for all subsequent and associated costs of the loan.
Principal This is the amount of money borrowed for the mortgage. The principal decreases as each mortgage payment is made.
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