Mortgage Refinance Tutorial
April 14, 2009

Here is what you will learn in this tutorial:

1. What does "saving money" on a refinance mean?
2. Should you finance the origination costs?
3. What hazards must be avoided?
4. Determining whether or not you will save money: what is the "break-even" period?
5. How do you find the break-even period?

This tutorial is for those who want to save money on their one existing fixed-rate mortgage. If you need to raise cash on your refinance, if your existing or new mortgage is an ARM, or if you now have two mortgages, drop down to the last paragraph.

What Does "Saving Money" on a Refinance Mean?

Saving money means that over the period you will hold the mortgage, the total costs net of offsets (savings) will be lower on the new mortgage than on the existing one.

On both mortgages, costs include monthly payments of principal and interest, and lost interest on those payments, meaning the interest that could have been earned had the payments been invested. On the new mortgage, costs also include points and other settlement costs that are paid upfront or added to the balance. Cost offsets on both mortgages are tax savings on interest and points, and reduction in the loan balance during the period the borrower expects to have the loan.

If the interest rate on the new mortgage is lower and there are no points or other settlement costs, the new mortgage will save you money, even if you pay it off after one month. However, most borrowers incur refinance costs upfront that must be recovered over time through the savings generated by the lower interest rate. The critical number is the "break-even period" -- the minimum length of time you must hold the new mortgage to make the refinancing pay.

Should You Finance the Origination Costs?

Many borrowers who refinance finance the upfront costs. They add the costs to the mortgage rather than pay them in cash. Usually, this reduces the gains from refinancing because the borrower must pay interest on the upfront costs at the mortgage rate. Pay the costs in cash if you can manage it.

What Hazards Must Be Avoided?

The refinancing market is something of a jungle, but you are safe if you observe one basic principle: You cannot save money on a refinance unless the interest rate on the new mortgage is below the rate on the existing one. Those who argue that you will profit by refinancing into their mortgage at a higher rate are either fooling themselves or are out to fool you.

Some con artists will show you that your total interest payments will decline if you refinance into their higher-rate loan. However, they get that result by assuming that you will repay your new mortgage (but not your old one) on an accelerated (biweekly) schedule. You don’t need to pay a higher rate to accelerate your repayments.

Some others will show you that your monthly payment will decline if you refinance into their higher-rate loan. However, they get that result by extending the term. If your current mortgage does not have many more years to run, an extension of the term can reduce the payment by more than the higher rate increases it. If you do it, you pay for it big time in the form of a higher loan balance in future years.

Beware, some mortgage calculators calculate a break-even period by dividing the upfront costs by the reduction in mortgage payment. This is a phony break-even because it ignores changes in the loan balance, tax savings and lost interest.

Determining Whether or Not You Will Save Money: What Is the "Break-Even" Period?

The break-even period is the number of months before the savings from the lower rate completely offset the upfront refinance costs. Even if you are not sure how long you will have the mortgage, if you are confident that you will have it longer than the break-even period, you know the refinance will pay.

To see a sample set of break-even periods, click on Sample Break-Even Periods.

How Do You Find the Break-Even Period?

You find it in two steps. In step 1, you collect the following information:

Your Income Tax Rate: This is the tax rate you pay on your last dollar of income. If you pay only Federal income taxes, it is the highest of the Federal tax brackets you used. Currently, these brackets are 10%, 15%, 25%, 28%, 33%, and 35%. If you also pay state and/or local income taxes, you should add the highest bracket you used in connection with these taxes. For example, if your highest Federal tax bracket is 28% and the highest state bracket is 5%, you should enter 33%.

Remaining Term on Your Existing Loan: This is the number of months until the balance is paid off if you continue making the mortgage payments you are making now. It is the original term less the number of months that have expired since origination, provided a) you have a fixed-rate mortgage, and b) you have not made any extra payments. If one or both of these conditions does not hold, or if you do not know how many months remain on your existing loan, use the Monthly Payment Calculator 7a to find your remaining term.

Term on New Loan: For borrowers looking for a fixed-rate mortgage (FRM), a 15-year term is the best bet if you can afford the payment. Most borrowers who take adjustable rate mortgages (ARMs) opt for 30-years, tho 40-year terms are available.

Whether Points and Other Costs Are Paid in Cash or Financed: Finance the costs if you must, but doing so will extend the BEP. In some cases, having to finance the costs could swing the refinance from profitable to unprofitable.

Step 2 involves entering this information into Mortgage Refinance Calculator 3a.

Using Other Refinance Calculators

If you have two mortgages, or your current mortgage is an ARM, or you need to raise cash, calculators 3b-3e will meet your needs. If you also have non-mortgage debt that you wish to consolidate in your mortgage, use calculators 1a-1c.

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