How to Know If Refinancing Is Worth It

by Team Dinks on July 7, 2010 · 10 comments

Mortgage Refinance - Dollar House

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)



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