When refinancing makes sense
You can save thousands of dollars each year by refinancing (refi) an existing mortgage to a lower rate loan.
Here are a few questions you must answer before talking to a loan officer:
- How long you will live in the home
- How much are the closing costs
- Is the house worth more than the mortgage balance
It wouldn’t make sense to refi if you plan to move next year and any closing costs need to be recouped before you go through the hassle of processing a refinance. Using a “Break Even” analysis can help make sense of a mortgage refi.
The Break Even Analysis
To pay for refinancing costs we need to make sure to look at how much interest we can save each year.
Let us pretend you bought a $200,000 house on a 30 year mortgage at 5.5% interest about 5 years ago. You would have paid the principal down to $184,921. How long would it take to recover $4,000 in closing costs to make it worth the trouble?
Refinancing the current balance to a 4.5% rate would save you $1,849 a year or a 3.5% rate saves $3,698, almost all the closing costs in one year. If you plan on living in the home for more than 2 years then refinancing makes sense.
Cut the term in half
Take that 30 year mortgage and make it a 15 year and you can save even more interest. A $200,000 house at 3.5% for 30 years will cost a buyer $123,312 in interest alone. That same house will cost a 15 year mortgagor only $57,358 in interest – $65,954 less (that’s more than half saved!)
If you have 25 years left then try a 10 year refinance. This is not a common loan but imagine having no payments in the next decade!
The interest rate for 15 year or 10 year mortgages are lower than that of a 30. This gives you the best of both worlds: A lower interest rate and a shorter pay-off date.
What if I can’t afford to refinance into a lower term?
The final detail for making sure refinancing makes sense is to consider the monthly payment. We recommend your payment be no more than 25% of your take-home pay. This ensures you don’t get into a bind so you to have some money to throw at extra principal payments in the future.
You could choose a longer term note, but this could prevent you from paying the mortgage off in half the time.
I talked more about refinancing and all the possible financing vehicles (balloon, ARM, interest only) in the MoneyPlan SOS Podcast Episode 36.
Shop Around For The Best Refi
Believe it or not, you can get different deals from different mortgage companies. While a fixed-rate 15 year mortgage ends up being the same no matter where you get it, the closing costs and interest rate could be different. It might make sense to pay points or negotiate away some of the closing costs.
Try shopping the following for the best deal:
- Credit Union if your mortgage balance is low
- Local banks to get more personalized service
- Churchill Mortgage if you don’t have any debt and use eCredable to prove your credit-worthiness
On a final note, I would not recommend accepting refinancing offers in the mail. We have less than 3 years left on our mortgage but Golden Oak Lending believes we can pay it off quicker with their 15 year loan. That is a refi that doesn’t make sense!