Anybody who follows the financial news will notice times when mortgage interest rates seem to have shifted to a downward trend, meaning the average mortgage rate of today is likely lower than it was 6 months or a year ago.
It is at these times that we wonder if we are missing out by not refinancing our home to take advantage of the better rates.
The answer has to do with the simple concept of answering the question: will it cost me more than it saves me to refinance my house?
Knowing When To Refinance
If you are asking, “Does it pay for me to refinance my house?,” you are going to need to do just a bit of math. Don’t worry, it’s pretty easy stuff.
The easiest way to figure it out – the one that most people use – is a “roughly right” rule of thumb, but one which may yield a slightly incorrect result. That rule of thumb is to divide the reduction in the monthly mortgage payment (with the new loan) by the cost of the refinance.
For example, if your new, post-refinance payments are $100 less than with your existing loan and your refinance cost you $2,000, then you would be better off refinancing if you plan to stay in your home for at least 20 months ($2,000 / 100 = 20).
The trouble with this calculation is that it does not take into account the fact that your old and new loans will be paid down at different speeds.
How To Calculate Your Refinance Breakeven: The 3 Factors
To calculate whether you should refinance your home in a more accurate fashion, you need to take into account 3 factors:
1. The difference in your monthly payments (old versus new loan)
2. The cost of the new loan
3. The difference between the outstanding loan balance after some period of months, such as 10 months (old versus new loan)
So, for example, let’s say you want to know: “Would be the case that if I refinanced my mortgage now and stayed in my home for at least 10 months, how much would I have gained or lost by refinancing?”
To figure out the answer, first determine the difference between your old loan (current loan) and new loan’s monthly payments. Let’s say it’s $100. Then, figure out how much your loan would cost (be sure to include any closing costs such as points paid, title fees, etc.). Let’s say that number is $2,000. Then, let’s say that you use a mortgage calculator and find out that, with the new loan, your remaining loan balance would be $1,100 lower in 10 months than it would if you kept the current loan.
In that case, the factors used to calculate your net savings/cost of the refinance in 10 months are:
a. savings in monthly payments at month 10: ($100 savings x 10 months) = $1,000 in savings
b. cost of loan: $2,000
c. lower balance at month 10: $1,100 lower loan balance
The result is calculated as: ($1,000 + $1,100) – $2,000 = $100. Meaning, refinancing results in a savings of $100.
So, we can see that in this case the breakeven came at around month 10 (which is the number we happened to try out), not month 20 as we had calculated when using the rule of thumb that ignores the difference in loan balances. hint: try different month periods to see how the answer changes.
Use this simple calculation method to determine whether it pays for you to refinance your home.
Of course, to make the calculation work, you will want to get some offers from at least 2-3 lenders so that you can have them determine your new monthly payments for a would-be loan that you can plug into the equation.