People refinance all the time, for various reasons but always with the idea that they make a smart financial move. In actuality, some of them do not. Because they don’t know how to calculate the cost of refinancing. They look only at the lower interest rate, or the lower monthly payment.
To figure out if you’re making or losing money or breaking even when you refinance, you need to have the answer to 3 questions:
1. How much will your refinance cost you?
2. How much will you save each month by refinancing?
3. How long are you likely to stay in your home without refinancing?
The cost of getting a mortgage varies from mortgage broker/bank to mortgage broker/bank, sometimes by thousands of dollars. In other words, it’s possible that your refinance makes sense with one mortgage broker or bank but not with another.
When I say ‘closing costs,’ I mean all the costs, not the advertised ones. A lot of times, you see low closing costs because not all the fees are included (not nice but some use this to reel prospects in). When you make your calculations, make sure that you’re including all the expenses related to your closing.
You need how much will your new monthly payments are going to be (without rolling the closing costs into them), so you can compare to your existing payment. Obviously, the lower the new interest rate, the lower the new monthly payments. However, lower monthly payments don’t necessarily mean your refinance makes sense.
An example. Say your new mortgage will cost you $2,400, and after you refinance, your monthly payments are $100 lower. That means that under this scenario, you break even after 24 months.
If your mortgage cost you were $4,700, and your monthly payments were $100, it would take 47 months before you broke even.
What if the mortgage broker with $4,400 closing costs gets you a better interest rate, one where you save $130 a month? Well, 4,400 divided by 130 gives 36.15. You’d break even after 36.15 months.
By the time 36 months have passed, you’d have saved $1,000 beyond the cost of the refinance if you’d have gone with the $2,400 refinance even though it comes with a higher interest rate.
However, 10 years later, that is to say, 120 monthly payments later, the refinance with the $2,400 closing costs saves you $9,600 ($100/month X 120 = $12,000 – $2,400 (closing costs). The $4,700 refinance saves you $10,900 ($130/month X 120 = $15,600 – $4,700 (closing costs).
Which means you really need to make the refinancing decision based on how long you plan to hold on to the refinanced mortgage loan. Obviously, the best scenario is to get the lowest rate coupled with the lowest costs. If that cannot be, then you have to determine if you need to get your savings fast or not. If you do not, it can make sense to pay higher closing costs if it gets you a lower mortgage interest rate.