Rule of Thumb for Refinancing

I have seen lots of tips on when it makes sense to refinance your mortgage, but I disagree with some. Here is my rule of thumb on whether it makes sense to refinance - the key for me is an apples to apples comparison:

1) Establish the loan amount to compare - to keep it simple start with your current loan balance - in my case the current loan balance is $236,100.

2) Establish a monthly payment at your current mortgage interest rate. Its key to remember this is DIFFERENT than your current mortgage payment. For instance my current mortgage payment is $1278.57, but if I were to finance my current balance of $231,600 @ my current mortgage interest rate of 4.87% I would find the mortgage payment to be $1,249.46.

3) Establish a monthly payment if you refinanced at the new rate. I was looking at getting a 4.375% 30 yr loan so if I financed our existing balance of $231,600 the new monthly payment would be $1,178.81.

4) Estimate your closing costs (ignoring pre-paid items like pre-paid interest and escrow funding for property taxes and insurance). In my case I estimate that my net closing costs will be $616.95 after some credits provided by the lender.

5) Estimate a after-tax monthly savings - Calculate the difference of the monthly payments $1,249.46 - $1,178.81 = $70.65/mo. That amount is before any tax benefit. I assume that the difference would otherwise be fully deductible, and $70.65 / 33% = $47.33/mo net benefit.

6) Calculate the number of months it would take to save back your closing costs. For me that would be the net closing costs ($616.95) divided by our monthly net savings ($47.33) = ~ 13months to save back our closing costs. Keep in mind in this example our actual monthly payment change is $1278.57 - $1,178.81 = $99.76/mo.

Hopefully you can see why I pulled the trigger - if it only takes us 13 months to pay back our closing costs then we will begin to see a net benefit there after.

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Comments (3)

Good work 2million! I like the way you think!

Posted by Steve | August 12, 2010 3:55 PM

How are the closing costs so cheap? Who is the lender?

Posted by Jason Walker | August 20, 2010 6:34 PM

You are leaving out some very important factors and add in some that don't really equate.
I'm not sure what the point is of establishing your current mortgage payment at your current rate and seeing the DIFFERENCE as you call it. What is the point of this calculation? I don't see the point, but maybe I'm missing something.

What you are leaving out and forgetting to include is how long you are refinancing for.
If you initial 30 year mortgage is being refinanced once again into a new lower interest rate but again another 30 year mortgage, you might be saving initially with a lower payment, but if you are adding on 5 more years to your loan you aren't saving anything.

Now, if you refinanced to a 15 or 20 year mortgage and your payments were close to the same, then yes you are saving money over the long time while keeping your payments the same.

There are many variables that need to be known when making a refinance decision. Are you planning on keeping the house and living there for a long time or using it as an investment property in the future? If so, then you want the lowest interest rate possible and rolling into points/closing costs would probably save you more money than you realize over the long term.

Refinancing is not as simple as it sounds. The only reason you would refinance into another 30 year mortgage is if you will continue to make payments at a faster clip, i.e. 15 year, 20 year pace etc. Any rate which is lower than your current time payoff horizon, otherwise you are paying for 30 years on top of the length you have already paid on your mortgage, and let's say it's 5 years. Well that new $1,178.81 payments x 12 months over 5 years adds up to $70,728.60 - So where is the savings?

Sure you saved $70 or so a month, but let's do the math. $70 x 12 x 30 years = $25,920.00

You saved $25,920.00 monthly but since you extended you payment by 5 years you added $70,728.60 for a net loss of $44,808.60

The bottom line, if you are resetting your loan you are losing unless you are paying it off at a faster rate, i.e. 15 or 20 year mortgage etc.

Posted by RayJ | September 9, 2010 9:45 AM