You hear the ads. You see the mailers. Refinancing can drop your rate. Refinancing can save you money! But is it right for you?
How do you know whether or not a mortgage refinance is the right choice? There are a few factors you must consider when looking into a refinance and my hope is to provide you with the information so you can decide whether or not refinancing will actually save you money or hurt you.
What is a Refinance?
First, we need to make sure we understand what a mortgage refinance is. When you refinance your mortgage you are paying off one mortgage with another. That’s pretty much it. Simple, right?
There are a couple of different type of mortgage refinance options.
- Rate and Term Refinance
- Cash Out Refinance
Rate and Term Refinance
Rate and term refinances mean you will have a new mortgage with a new rate and new term. You pay off your existing mortgage at whatever rate you have and with whatever remaining term you have to get a new mortgage with a new rate (hopefully lower) and a new term (30 years, 15 years, etc.).
Cash Out Refinance
Cash out refinances work very similar to rate and term refinances with one big distinction – cash out. With a cash out refinance you are not only getting a new mortgage with a new rate and term but also additional funds out from the equity you have in your home.
Calculate Monthly Savings
One of the first steps you will want to look at is the monthly savings you can realize from completing a refinance transaction.
Rate and term refinances are pretty straightforward. You simply take your principal, interest and mortgage insurance on your current mortgage and compare it to the principal, interest and mortgage insurance of the new mortgage. What is the difference in payment? That is the monthly savings you will realize with a rate and term refinance.
Cash out refinances are not quite as simple. The reason is because, in some cases, a cash out refinance will increase your monthly mortgage payment. If you are using a cash out refinance to pay off other debts then we can calculate a monthly savings. Take your current principal, interest and mortgage insurance payment along with the minimum monthly payments on any debts you will be paying off with the cash out refinance. Compare that number to the new principal, interest and mortgage insurance payment on the new mortgage. Whatever that difference is will be your realized monthly savings.
The problem gets very complicated when you are getting cash out to do something other than paying off a monthly debt, such as a home remodel. In that case you may not realize a monthly savings but instead a higher quality of life or more equity when you sell. If this is the situation you are in the value of the refinance will have to be determined by you and the benefit you believe you will realize.
Determine Your Closing Costs
Have you ever heard of a “no-cost refinance”? I can tell you right here and right now they don’t exist. There is not a mortgage refinance that does not cost you something. The lender has to get paid some way, right? They aren’t just doing refinances for free. Would you ever imagine going to the grocery store and expect a FREE MILK day? Yeah, I didn’t think so. Same thing on a mortgage refinance – there is no FREE REFINANCE day there either.
What do they mean when they say “no cost refinance” then? What they mean is that the lender is either increasing your rate or your loan balance to cover the costs of the mortgage. Either way you are paying for it. Here is a simple way to calculate the actual cost being added to your mortgage.
Calculate the difference between your existing mortgage payoff balance (not what appears on your mortgage statement but the payoff balance) and the new mortgage amount the lender has calculated along with any out of pocket expense required by your lender. In other words if your current mortgage payoff balance is $260,000 and your new mortgage is $263,000 and they are requiring $700 from you for an appraisal then you would do the following calculation:
($263,000 + $700) – $260,000 = $3,700 in closing costs.
If the mortgage lender is rolling the closing costs into the rate your mortgage balance should not be increasing at all. In this case you would use $0 for your closing costs.
You now have enough information to complete a simple break-even calculation on the refinance. This is the simple version because it does not factor in all the details that will impact you financially but it will give you a general idea of whether a refinance could benefit you.
Take your total closing costs and divide it by the monthly savings. Here is an example of what this might look like:
$3,700 in closing costs and $100/mo savings
$3,700 / $100 = 37
What this shows is that at a savings of $100/mo you will earn back the closing costs from refinancing within 37 months. In this scenario you would then ask yourself if you believe you will either sell or refinance within the next 37 months. If the answer is no then the refinance will likely benefit you. If the answer is yes, you would sell or refinance within 37 months, then you would have paid money to refinance that would not have benefited you financially.
More Accurate Break-Even
The above calculation works pretty well for most situations to give you a general idea of whether a refinance could benefit you and when you will realize the benefit. For those of us who want to know with more certainty as to whether the refinance will actually benefit us we have to look at some additional factors including:
- Change to the Mortgage Term (remaining time to pay off mortgage)
- Escrow balance refund from mortgage being refinanced
- Skipped monthly payment the month after your refinance closes
All of these have a financial impact on you and should be considered for the most accurate refinance calculation.
Let’s say you have been paying on your mortgage for the last 10 years and you have just 20 years remaining. Now you complete a refinance to save .25% on your mortgage rate but you get a new 30 year fixed mortgage. You just added 10 years to your repayment term. That may or may not be the right decision depending on the monthly savings you are realizing and the cost of the refinance. The key is to make sure that is factored in.
How? Well, I wish I had a handy little calculator like I do above that would calculate this all out for you. It is a pretty complicated calculation but the good news for you is that I offer a free refinance analysis for homes financed in the State of Colorado.