How Do You Know Whether Mortgage Refinancing Pays?
If you took out a 7.5%
mortgage in 1994 and still have it, refinancing it in a 3.5% market is a
no-brainer; you don’t need much analysis to know that refinancing into
today’s rates will pay. The only possible reason that such mortgages
still exist is a marked deterioration in the borrowers’ credit, in the
value of the home, or in the borrower’s mental capacity.
If you took out a 5.5% mortgage in 2004, the case
for refinancing is not as strong but, barring deterioration of the types
indicated above, it is strong enough to move with confidence.
The challenging case is when your mortgage is at
4% from 2014. This is a situation where the rate reduction might or
might not be large enough to offset the costs of the refinance. This
article will explain the valid approach to answering the question, and
an invalid approach used by loan officers that is all too common .
Factors That Affect the
Profitability of a Refinance
A refinance pays if the sum of all the costs
arising from the refinance during the period you expect to have it is
less than the sum of the costs of the old mortgage over the same period.
Costs on only the new loan include points and other origination charges
paid at closing. Costs on both the new and existing mortgage include
monthly payments of principal and interest, mortgage insurance premiums
if any, and lost interest on upfront and monthly costs. In both cases,
tax savings and the reduction in loan balance are benefits that must be
deducted from total costs.
Yes, this is a formidable
list but I have made it easy for you with my refinance calculator 3a
Refinancing One FRM Into Another to Lower Net
Cost. The calculator
will prompt you for all the required inputs and indicate why they are
needed. This calculator assumes that you have only one fixed-rate
mortgage that is refinanced into another, and that you don't take any
cash out of the transaction. Other refinance calculators are
available for borrowers who have an adjustable rate mortgage, or a
second mortgage, or want cash from the transaction. See Find
a Refinance Calculator.
Calculator 3a indicates that the borrower with a
4% 30-year mortgage that is 3 years old would benefit by refinancing it
into a new 3.25% loan, and benefit even more by selecting a 15-year
mortgage at 2.5%. With a loan balance of $360,000, the savings over 10
years would be about $17,000 on refinancing into a new 30-year, and
about $49,000 when the new loan is for 15 years.
Don’t Be Led Astray by a
Spurious “Break-Even Period”
Another approach to whether or not you will save
on a refinance is to calculate a break-even period – the period over
which costs of the old loan and the new loan are equal. The larger the
spread between the new interest rate and the rate on your existing loan,
and the smaller the cost of the new loan, the shorter the break-even
period. If you are confident that you will have the new mortgage longer
than the break-even period, you will benefit from the refinance.
Calculator 3a shows the breakeven period, in addition to the cost
comparison over the period you specify.
But beware! The
break-even period is not the cost of the new loan divided by the
reduction in the monthly mortgage payment. Many
loan officers use this rule of thumb, which completely ignores how
rapidly you pay off the new loan as opposed to the old one. Borrowers
following this rule would never refinance into a shorter term loan
because of the increase in payment, although the total benefit including
the pay-down of the loan balance is substantially greater on refinancing
into a 15-year loan, as indicated above. The rule of thumb does not work
for any borrower who is concerned with how long they have to pay, which
should be every borrower.
Combining the Refinance
Analysis With Mortgage Shopping
The answers generated by refinance calculators
are no better than the current mortgage prices the user must enter to
make the calculators work. The calculators on my web site were developed
at a time when users were on their own in finding the prices at which
they could borrow in the current market. But that is no longer the case.
You can now price shop and assess whether a refinance will pay in a
single operation on my site.
Follow the “Refinance Mortgage Shoppers” path
which at Step 2 will give you an input form that includes all the
factors that affect your mortgage price in today’s market, and also
includes information about your current mortgage. The program will show
the costs over the period you stipulate, using the best prices quoted by
the lenders who report their prices to my site, on all the new loans for
which you qualify, and also for your existing mortgage if you retain it.
You can thus shop for the best terms on a new loan, and you can select
the new loan type that generates the largest saving over your current
loan.
