When you have a mortgage, you’ve committed to pay your lender a specified interest rate – or a variable interest rate – for a period of time. The only way this rate or period can change is by refinancing.
When interest rates go down, refinancing can mean essentially trading your higher-interest mortgage for a less expensive one. If you get a huge raise at work, refinancing can allow you to pay your mortgage off in 15 years instead of 30.
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Sounds great, right? It is, sometimes. But, in certain situations, you may not save money by refinancing. In others, it may actually end up costing you a lot.
The catch with refinancing comes in the form of “closing costs.” Closing costs are fees collected by mortgage lenders when you take out a loan, and they can be quite significant. Closing costs can run between 3-6 percent of the principal of your loan. If you still owe $200,000 on your home when you refinance, you could pay $6,000-$12,000 in fees!
The decision to refinance comes down to this: Will the terms of your new loan definitely save you more than you’ll pay in closing costs?
Will a refinance actually save you money?
This is where we get into some number crunching.
Take the cost of the refinance – closing costs and any other fees your lender charges – and divide them by the amount of money that you will be saving each month as a result of doing the refinance.
Here’s an example:
Let’s say that you are considering refinancing your 30-year, $200,000 mortgage from a current rate of 5.50 percent to a new 30-year mortgage at 4.50 percent.
It will cost you $6,000 in fees. Your current monthly payment at 5.50 percent is $1,136, and the new payment at 4.50 percent will be $1,013. That will result in a reduction in your monthly payment of $123.
In order to calculate the refinance recovery period, divide $4,000 in closing costs by the $123 per month that you will be saving as a result of doing the refinance. In this case, the recovery period will be roughly 49 months.
As long as you plan on staying in the home for more than 49 months – or a little over four years – the refinance will save you money.
Be careful when refinancing into a shorter term loan
When interest rates are low, there’s a strong motivation to reduce the term of your loan.
On paper, that makes perfect sense. But in my own time in the mortgage business, I saw a trend in which many of the people who refinanced a 30-year loan into a 15-year loan came back a year or two later and wanted to refinance back to a 30-year loan.
The reason for this is simple: As much sense as a term reduction makes, it results in a much higher monthly payment. Much higher.
Let’s look at another example:
Once again, let’s say you’re considering refinancing your current 30-year, $200,000 mortgage at 5.50 percent into either a 30-year loan at 4.50 percent or a 15-year loan at 4.25 percent.
How do the payments look?
- 30 year at 4.50 percent: $1,013
- 15 year at 4.25 percent: $1,505
- Difference: $492
As you can see, the difference between the 30-year payment and the 15-year payment is substantial, despite the fact that the 15-year loan actually has a slightly lower rate of interest. The 15-year loan is certainly the better choice from a long-term financial standpoint, but can you afford to pay nearly $500 extra each and every month? That’s almost $6,000 more per year for the next 15 years.
You can use our mortgage calculator to run your own numbers.
A lot of homeowners are not aware of how much of a burden that extra expense will be until they actually get into the loan and start making the monthly payments.
The value of refinancing comes down to comparing the money saved in the long term to the fees paid out in the short term. The more confident you are that your current home will be yours for many years, the more you could save by refinancing to a lower rate.