Wow! The average interest rate for a 30-year fixed-rate mortgage dropped to 4.74% in June. That historically low rate should pique your interest if you have a mortgage or are thinking about buying a home.

## What is a Mortgage Refinance?

Refinancing is when you take out a new loan in order to pay off an existing loan balance. You basically swap out a higher-interest loan for a lower-interest one, which decreases the amount of interest you have to pay. That sounds easy enough, but of course, there’s a cost for doing a refinance. It seems like it takes a village to close a loan and everyone gets their cut. Fees go to the lender or mortgage broker, the property appraiser, the closing agent or attorney, the surveyor, the local government, and maybe more people, depending on where you live.

## How to Qualify for a Mortgage Refinance

Each lender has different requirements for doing a refinance. Most will require that you have a certain percentage of equity in your property—typically 20%. Equity is the difference between what your home is worth and what you owe on it. For example, if your home is valued at $225,000 and you have a $200,000 mortgage, you have $25,000 in equity, which is 11% of the value.

## Use the Home Affordable Refinance Program (HARP)

However, there’s help if you have too little equity or if you owe more than your home is worth. You may be eligible for the Home Affordable Refinance Program (HARP) if you meet some basic requirements:

1. Your mortgage is owned or guaranteed by Fannie Mae or Freddie Mac

2. You’re current on your payments

3. Your mortgage balance doesn’t exceed 125% of your home’s value

Visit makinghomeaffordable.gov for full details and contact your lender about refinancing under this federal program.

## How to Know If You Should Refinance

The trick to knowing if you should refinance is to find out from the lender exactly how much a refinance will cost and how long it’ll take you to break even on those costs. In other words, when do you move from being in the red to being in the black on the deal? If you pay for a refinance, but don’t keep the home long enough to cover the costs, you’ll lose money. But if you do keep the property beyond the financial break-even point (BEP), you’ll feel like a genius because you’ll save money in the long run! I’ll give you an example in a moment.

## How to Figure a Refinance Break-Even Point

So how do you figure the financial break-even point on a refinance? It can be a little complicated, but don’t worry, there’s a great refinance calculator at dinkytown.com that can help you. Online calculators are not perfect; however, using a refinance calculator will show you how long you’d need to keep the property to recapture all your upfront closing costs, which is usually what most people want to know.

## Example of How Much a Refinance Can Save You

Here’s an example of how much doing a refinance could save you. Let’s say you bought a home in June of 2007 when the going rate for a 30-year fixed rate mortgage was 6.5%. Here are the loan details:

Home cost: $225,000

Down payment: $ 25,000

Mortgage: $200,000

Interest rate: 6.5%

Term: 30-year fixed rate

**Monthly payment: $ 1,264 ** (principal and interest only)

Now that you’ve been making payments for three years, your loan balance has decreased to approximately $193,000 and the prevailing mortgage rate has dropped to 4.74%. Let’s say the total closing costs for doing a refinance would be $5,000 and you have the cash to pay them up front:

**SCENARIO #1
**Mortgage balance: $193,000

Interest rate: 4.74%

Term: 30-year fixed rate

**New Monthly payment: $1,005**(principal and interest only)

Here’s another scenario where you don’t have the cash to pay the refinance closing costs upfront and you roll them into the new loan:

**SCENARIO #2
**Mortgage balance: $198,000 ($193,000 + $5,000)

Interest rate: 4.74%

Term: 30-year fixed rate

**New Monthly payment: $1,031**(principal and interest only)

If you rolled the closing costs into the new loan (scenario #2), your savings would be $233 ($1,264 – $1,031) per month, or $2,796 per year. So if you kept the home for two years, you would recoup a savings of $5,592, which is more than enough to offset what the refinance cost you ($5,000).

Or if you were able to pay the closing costs upfront (scenario #1), your savings would be $259 ($1,264 – $1,005) per month, or $3,108 per year, and keeping the property for just a year and a half would allow you to break even on the $5,000 closing costs.

## Carefully Weigh Refinance Costs Against Savings

When the interest rate you’re paying is at least 1% higher than the current rate for your type of mortgage and you plan on keeping your home for a few years, it’s time to run the numbers. As I mentioned, it’s as simple as entering some information into an online refinance calculator. Be sure to carefully weigh all the costs of doing a refinance against the savings you expect to receive. A refinance can save you many thousands of dollars in interest over the life of a loan—and that’s money you could save for your emergency fund or invest for your retirement instead.

(Photo by The-Lane-Team)

{ 10 comments… read them below or add one }

I feel like this is bad advice – its not a correct break even analysis as your mortgage term resets to 30years on a refinance and your only comparing the monthly payment in your analysis, while your payment schedule increases by 3years.

@2million The break even point indicates how long it would take you to recapture the upfront costs for doing a refinance. This is important because most people don’t keep their mortgages for the full 30 years–they end up selling long before that. But if you did keep the original loan in my example, you’d pay $255,088 just in cumulative interest over the 30 years. However, if you refinanced you’d only pay $169,021 in cumulative interest over the reset 30 years. Even if you add in the interest you already paid for the 3 years prior to the refinance ($3247), you’d still save $82,820 in interest if you refinance! You can always choose to refinance for a different term like 20 or 15 years if you want to save even more money. I wouldn’t call saving over $82,000 in interest bad advice–the numbers tell the story!

Laura,

Im not disagreeing that your example could save money by refinancing – thats obvious given the significant reduction in the interest rate; I implying your approach is oversimplified and could lead to bad decisions about refinancing because your break-even analysis doesn’t factor in the total picture – only the monthly payment. Perhaps I misunderstood your intent.

@2million No problem. I recommend that anyone who’s considering doing a refinance use a good refinance calculator like the one I mentioned in the article at http://www.dinkytown.com. It takes several variables into consideration to help you weigh all the costs of doing a refinance against your potential savings.

I’m so used to posting as Money Girl–but that’s me!

Laura, while I don’t have a mortgage to refinance, I think that this is really great information. I love these type of data analysis posts, because it forces each individual to figure what works for them. It’s recognizing that there isn’t necessarily a one size fits all solution for everyone.

@2million – I think you may have misunderstood the Laura’s use of of break even point is how many months it takes for your reduced monthly payment to equal your refinance cost. Or perhaps to consider it a different way. Assume you did refinance, and you continued to pay the exact same amount towards your mortgage ($1264) you would be able to completely pay off your new 30 year mortgage just over 20 years. 7 years sooner than you would have been able to without the refinance! As Laura suggested the main thing is that you plan to stay there long enough to hit the break even point.

@2million is on target.

To help illustrate, say the mortgage were 15 years into the term, 15 yrs left. A refinance out to 30 years may lower the payment at an even higher rate, creating a false “break even.”

My advice above is to take the new rate, but calculate a payment as though the term were 27 years, that will tell you your actual savings, and provide a better, more accurate break even.

I hope this answer helped clarify this.

@Joe Taxpayer, @2million,

Joe, thanks for clearing things up. You are correct that my analysis of break even was skewed given that it pushes the loan end date back. I guess there’s two interpretations of the break-even point. One being the point at which you recouped your initial investment of $5000 (in terms of liquid cash) and the other being the more correct one of when you recoup your $5000 overall. The danger is using the former, is that you could potentially spend more overall perhaps to just alleviate some short-term pressure from mortgage payments. Sorry @2million for mis-interpreting your statement, and thanks @Joe Taxpayer for clearing things up. I guess this is what I get for trying to do math on the fly =P

If you’re deep into a mortgage (15 years into a 30-year fixed product) you’ve already paid more than half of the interest. That’s because loans that amortize have a payment that’s made up of mostly interest in the beginning and the interest portion gradually shifts to $0 by the end of the loan. So if you plan on staying in the same home until you pay off the mortgage, run an amortization schedule for your refi options at 15-, 20-, and 30-years to compare how much cumulative interest you would pay with each one. You can use an Excel amortization template to do this or have a lender run various am schedules for you. However, for many people who are having difficulty making their mortgage payment right now (and can’t sell the property), lowering the monthly payment is the goal so they can keep their home. Once they get back on their feet, they can refinance for a shorter term to save on interest expense.

Thanks

Mario