Should I refinance my mortgage? How to decide.
Too many people make the decision about refinancing their mortgage without actually doing any calculations. They just see a lower interest rate and assume that if it’s a certain amount lower than their current rate that it must be a good idea to refinance. Plus there are plenty of articles out there that just give blanket guidelines, like half a percent, or one percent lower, as being reason enough to refinance. But the reality depends on your circumstances, and you need to calculate whether you will recoup the closing costs in time to reap the benefit of a lower rate.
Say you have a $150,000 mortgage at a 4.5% interest rate for 30 years. Your current payment is $760, assuming you have at least 20% equity and so don’t have to pay PMI (private mortgage insurance). This does not include your property taxes or homeowners insurance that is often included in your mortgage payment. You need to separate those out for the purpose of this discussion.
Then let’s say you have an opportunity to refinance at 3.5% (also 30 years), with closing costs of 2.0%. Should you take that deal, or not?
It’s important that you look into what the closing costs will be, as it makes a huge difference in the calculation. They could range from 1.5% to 4%, so make sure you know what they will be for the new rate you’re looking at. If we stick with that 2% number for closing costs, you will pay $3000 for the refinance, and you need to recoup that $3000 in savings each month because of your lower mortgage payment. And how long it takes to recoup that money is what you need to consider.
The new payment at a 3.5% rate would be $674. So your payment goes from $760 down to $674 each month, saving you $86/month. If you divide 3000 by 86, you get 35 months for your “break even” period. In other words, it will take you about 35 months, or just under 3 years, to save on your mortgage payments what it cost you to refinance. After that point, all the savings is gravy.
So you need to think about what your plans are for living there. Are you absolutely sure you won’t want or be forced to move before the 3 year breakeven period is up? How stable is your job situation? Do you have a growing family that might outgrow this house before then? Are you in the military or a ministry job that makes you move every so many years? What other factors might influence whether you are still living here between now and when that breakeven period is up?
And the closing costs really matter. If you can get 1.5% for closing costs, you only need to recoup $2250 instead of $3000, and that $86 savings will accomplish that in 26 months instead of 35 months….not bad. But closing costs of 3% mean you have to recoup $4500 instead of $3000, and that would take 52 months, almost 4 ½ years…ugh. May still be worth doing but I’m certainly gonna keep shopping for a better deal.
And a word about the term of your mortgage. I’d much rather you take out a 15 year mortgage than a 30 year mortgage if you haven’t bought a house yet, so that you become completely debt free much sooner. But don’t ever refinance a 30 year mortgage to a 15 year solely to reduce the term of the loan. You can accomplish the same effect of paying off your house in 15 years (or LESS) by simply paying extra principal on the mortgage each month. If you pay the same total amount each month as if it were a 15 year mortgage, with the extra over and above your regular payment going onto the principal balance, your house will be paid for in 15 years or less. In fact, why not shoot for paying it off in ten years or less?
So hopefully you now understand how to do the calculations and make a rational decision. Don’t just take the general rules of thumb you see on the internet. Figure it out with real numbers and compare the break even period to the realities of your life.
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