How Much Does It cost to Refinance, and How Long is the Pay Back?

With mortgage rates down near their all time lows again, refinancing is getting hotter (purchases, too). Low mortgage rates give you a chance to lock in the low rate for the long term, lower your payment and take some pressure off your budget. The rates now are the lowest I’ve ever seen and I expect when we look back at this a few years from now, they will seem like the bargain of a lifetime. But while rates are low, if you have compared rates you see in the newspaper or on-line, you might think rates are better than they really are. You might also see that some lenders are showing much lower rates than others, when the reality is that we all get our funds from the same sources, and the true rate shouldn’t vary from one lender to the next by more than an 1/8 or 1/4 of a percent.  So what gives? Why are some lenders able to show such low, low rates? Are they really able to do something that other mortgage lenders aren’t able to do?

The truth is, if it looks too good to be true, it probably is. Most consumers focus on the rate when comparing offers for their mortgage refinance, and mortgage marketers take advantage of this fact by advertising the lowest rates they can. But whether the lowest rate is the best deal for you is more complicated. The other thing you need to be aware of is how much the loan will cost you, and the lowest rates have the highest fees. We (mortgage bankers, brokers and banks) have a whole variety of rate and fee combinations we can offer every day. Each wholesale mortgage lender provides a matrix of price options every day. To get the lowest rate you will have to pay points (1% of the loan amount for each point, which is interest paid up front). I’ve seen Good Faith Estimates which show over 4 points (4% of the loan amount) charged to get a  below market rate. On the other hand, you can go in the other direction. The lender pays us (mortgage bankers, brokers and banks) extra money (called yield spread premium) for bringing in loans at higher rates. We can use this extra premium to pay off all your closing costs and give you a no cost refinance. Most borrowers elect to go with loans that have no points, or one point. The lenders don’t care how you do it, because they will get their money either now or in the future, and it works out the same to them based on their pricing models. For you, the consumer, it can make a big difference. So the big question is, what is the best way to refinance, paying extra money up front to get the lowest rate? Or does it make more sense to pay less money in fees upfront, but get a slightly higher rate?

 For a quick check to see if refinancing makes sense for you, and what the best way to refinance is, you need to consider 3 things:

How much will you save by refinancing?
How much will it cost to refinance?
How long do you expect to stay in the mortgage?

To find out the best option for you, you need to figure out your payback or break-even point. Let me work through the math to show you how this works (the rates and numbers here are all for illustration, not based on market rates now).

The first step is to determine, how much you will save?

For an example, let’s assume that you now have a mortgage with a $300,000 balance and a 5.50%% interest rate. This would give you a payment of $1,703 per month on a 30 year fixed rate loan. With improved rates, lest’s say you can now get the same  mortgage for 4.75% with a payment of $1,565 per month. This is a savings of $138 per month. That is a great rate and substantial savings. Does it make sense to refinance? Maybe, but we still need to know more.

The second step is, how much it will cost to refinance?

If you have spent any looking, you’ve found lots of ads for mortgage companies claiming they offer the lowest rates. But low rates don’t mean a thing if you don’t look at the closing costs too. Closing costs include title fees and the amount the bank charges to process the loan, which includes fees for credit reports, appraisals, processing and underwriting charges as well as Points (up-front interest). The cost can make a big difference for you. In the Chicago area it costs about $1,600 to close a refinance if you don’t pay any points or origination fees (another word for a point).  To see how the closing cost can make the difference, divide your monthly savings into the cost of refinancing ($1,600 divided by $138).  So in our example, it will take you less than a years worth of mortgage savings to pay off the up-front costs. Every month after that will be a true savings. If you are paying 2 points on the same loan ($6,000) plus the normal closing costs, ($7,600) the same loan will take almost 5 years before you would have any benefits from refinancing. The rate should be lower if the costs are higher, but you need to run the numbers on each to see which is the better deal. But there is still one more step.So the lowest rate isn’t always the best deal.

The third step is to estimate, how long do you expect to be in the mortgage?

With interest rates as low as they are, it may make sense to pay extra to lock in the long term savings. But if there is any chance that you may move, the savings may be wasted. In the above example, even if the rate is much better, if it takes 5 years to pay off the closing costs and you sell your home in 6 years, you wasted a lot of money on a refinance. On the other hand, if you stay in your home a full 30 years, you have made a lot of extra savings by paying more up-front to get the lowest rate. The thing to remember is that one size doesn’t fit all, and you need to go with the program that best fits your needs. Most mortgages last 7 years or less (before the homes are either sold or refinanced) so paying higher costs is not always the best deal. 

The idea that the lowest rate is the best deal can be a big problem. When you are comparing interest rate options, make sure that you compare apples to apples and not comparing a quote with points to one without. Pick the option that works for your needs, and don’t over pay to get a low rate if it costs you more in the long run. And make sure you get it in writing. Every lender should be able to give you a written Good Faith Estimate showing how much it will cost to close your loan, and how long your rate will be locked in for (make sure they are able to process your loan during their lock period). This is shaping up to be a great time to refinance, but you need to understand your options. If you would like a quote for a refinance that works best for your situation, give me a call.

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