Refinancing your mortgage can be a great way to lower your housing expense, but only if it doesn’t cost too much.
Interest rates move every day. In the last few years, it seems like the only way they move is down. Just when we thought they couldn’t get any lower, they drop again. (Check out current rates at bankrate.com)
In this low-rate environment, one question I get all the time is “how do I know if I should refinance?” There are a lot of numbers involved and it can seem pretty complicated. But it really doesn’t have to be.
Try Not to Focus on the Payment
First, let’s talk about what not to do.
Almost everyone I talk to about refinancing their mortgage starts the discussion with their ability to reduce their payments. It is usually something like, “omg, I can save $300 a month if I just refinance!”
No. Having a lower mortgage payment does not necessarily mean you are “saving” anything.
A lower mortgage payment could mean one of two things: you are putting less toward paying off your house OR you are saving on interest.
For example, lets say you got a 30-year mortgage 5 years ago at 4% interest. You’ve made your payments on time, and now you can refinance into a 30-year mortgage at 4% interest. Your payments will go down, but not because you’re saving anything! You’re just increasing the amount of time it is going to take you to pay off your house, which is actually going to increase the total amount of interest you pay during your lifetime.
It will be important to know what your payment will be after you refinance. But, refinancing simply to change your payment may be a bad idea. You’re focusing on the wrong thing.
Focus on the Cost
Deciding whether to refinance or not is actually pretty straightforward. The trick is to ignore all of the irrelevant information and focus on the two things that matter: the cost, and the interest rate.
To determine the cost: add up every single expense that you will incur if you refinance. This includes both out-of-pocket expenses and anything that will be rolled in to your new mortgage. These costs could include application fees, origination charges, underwriting fees, appraisals, credit report fees, certifications, title costs, points, and taxes.
The easiest way to figure these costs is some simple math:
- Add any money you have to pay directly during this transaction
- Add any increase in your loan balance between the old mortgage and the new
- Subtract any money you will receive if it is a cash-out refinance (which I almost never recommend)
For example, let’s say that you have a $200,000 mortgage today. You talk to your mortgage person and they say that you can roll all the costs into the new mortgage so that there’s no out-of-pocket expenses. And, they say that the new mortgage will be $205,000. Well, that means that it cost you $5,000 to refinance.
The Interest Rate
This one is easy. Simply subtract your new interest rate from your old interest rate.
You will save $1,000 per year for every 1% you reduce your interest rate on every $100,000 you borrow.
For example, let’s say that you are reducing your interest rate from 5.25% to 3.25% and that your balance is $200,000. That means that your interest rate is going down by 2 percentage points, saving you $2,000 per year on every hundred-thousand you borrow. You are borrowing $200,000, so you will save $4,000 per year in interest by refinancing.
Compare Costs and Savings
Now you can compare the costs and the interest savings to calculate how long it will take you to break-even. In our example, you are spending $5,000 to refinance and your new mortgage will cost $4,000 less per year in interest.
Then, just divide the upfront cost by the annual savings.
$5,000 / $4,000 = 1.25
In this example, it will take you 1.25 years to get your money back, or 15 months to be exact.
If you plan to be in your house for more than 1.25 years, then it makes sense to do this deal.
Rule of Thumb: 2-Year Break Even
Most financial coaches ask you how long you plan to stay in your house to determine if the break-even date is before or after some hypothetical future move.
I don’t really like that approach. Homeowners in the US hold on to their homes for about 13 years on average, according to research by the National Association of Realtors. But everyone is different and you may be closer or farther from a move.
Instead of trying to predict the future, I just make sure I have no plans to move and require that my break-even be less than 2 years before I consider refinancing.
In our example, if I’m going to spend $5,000 on something because it’s going to save me money, I had better be getting my $5,000 back pretty quick! If it’s going to take me more than 2 years to get my $5,000 back, I’m probably going to pass on the deal, even if I will probably still live in the house.
Back to the Payment
Now that you know whether it makes sense to refinance overall, it is time to revisit the payment.
Refinancing will likely change your mortgage payment. It can either go up or down depending on how you structure your deal.
If you refinance into a mortgage with a shorter repayment period your payment may go up.
If you push your repayment date farther out and/or get a lower interest rate your payment may go down.
Do not confuse the change in your monthly payment with your cost of refinancing. Just make sure that your refinance will break-even within 2 years of closing and that your payment is less than 15% of your monthly gross pay.
Focusing too much on the payment is a trap. Sure, it is important to make sure that you can afford the payment. But, that is only AFTER you determine the total cost of the transaction.
This is the same trap people fall into when buying a car. Sure, the monthly payments are lower when you lease a car… but the total cost is much much higher because you’re making payments FOREVER.
Refinancing your mortgage can feel pretty complicated and overwhelming. There are a lot of moving parts and numbers fly around, making it easy to get confused.
The best thing to do is ignore the stuff that doesn’t matter and look at the big picture.
- Add up all of the costs.
- Calculate your annual interest savings.
- Determine how many years it will take you to get your money back.
- If the break-even is more than 2 years out, don’t refinance.
I hope this has been helpful! I welcome your comments with your thoughts and questions. And, don’t forget to subscribe to the newsletter to get notified whenever a new article is posted.