How to calculate the cost vs. benefit of refinancing
Whether or not you should refinance will depend at least 3 things:
- The costs associated with refinancing
- The total monthly savings the refinance equates to.
- How long you plan to stay in the home or hold the loan
Once you calculate how many months of savings it will take to cover all the costs of refinancing (including any costs added to the principle balance of your loan) you can more easily assess whether or not it makes sense for YOU to refinance.
Here is an example. The numbers I'm using make for easy math. Assume the following:
- Current payment - $2500/month
- New payment - $2000/month
- Savings per month - $500
- Costs of refinancing* - $5500
- Months to break even - 11
In other words, you don't realize any real gain until the 12th month, but for every month following you'll save $500 per month. So if you plan on being in the home for longer than 12 months, refinancing looks pretty good.
*The costs of refinancing include loan fees, title fees, recording fees, legal fees, up-front pricing adjustments (if not being taken in the rate) and other fees that may vary by region. Check with a few professional lenders to find out if there will be other fees not mentioned here for your loan.
You may also need to pay a significant amount to re-establish an escrow account that pays your taxes and insurance. If you already have an escrow account, however, I consider this a wash. The reason is that once your old loan is paid off, whatever is left in that escrow account should be sent to you.
So should I refinance or not?
How long you plan to stay in the home and/or hold your current loan is a factor that is often overlooked. If you plan on selling my home in the next 2 years, but it will take you 4 years to break even, refinancing could be the wrong decision.
I've heard that if the interest rate is 1% or lower than my current rate, I should definitely refinance. Is this true?
There are a number of somewhat significant unavoidable expenses incurred in most refinances (appraisal, title insurance, loan costs, etc.). The more you can lower your rate, and therefore your payement, the quicker you will recoup the costs and begin to realize real gains. There is no magic number as to how much lower the rate should be. As stated before, if you plan on selling your home or paying off your loan before you would start to realize the benefits of refinancing, you should not refinance, even if you could have lowered your rate by 2%.
I've been offered a "no-cost" refi. That sounds like a good deal. Is it too good to be true?
A "no-cost" refi usually really means "no out of pocket cost to you". Often, the costs are simply rolled back into your loan, meaning if you owed $300,000 before the refinance, you may owe $305,000 after. Be sure to note this $5000 cost (in this example) as a real expense of refinancing. You will realize this "loss" when you sell the home or even just by having to pay it off with your loan (with interest...). Even though your monthly payment may be lower because you have re-cast your loan for a full term again, and because the interest rate may be better, there are real costs to you, so it really isn't a "no-cost" refi.
In some cases, the lender truly does pay the costs associated with refinancing, but in reality they are paying those costs with money they got by giving you a higher interest rate than you could have taken if you were to pay the costs yourself. Often they make additional profit off you when they do this, but not always.
- Do you have excellent credit?
- Do you plan to purchase a $300,000-$800,000 home within 90 days?
- Do you have a good down payment, or are you paying cash for your next home?
If so, you deserve someone on YOUR side of the transaction!
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