I am Peter Thompson, My goal is to take the mystery out of the home buying and mortgage process, and help home buyers understand their options.
Refinancing and the payback period ?
Mortgage interest rates move up and down based on changes in the economy. If you bought when the rates were higher, refinancing can be a way to reduce your interest rate and lower your payment. Because rates change frequently, you need to review your situation on a regular basis.
When does it make sense to refinance?
Whether refinancing makes sense for you, depends on 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?
There used to be a rule of thumb that said that the interest rate needs to go down by 2 percentage points before it makes sense to refinance. This is no longer the case. The process has been streamlined, and closing costs are usually less, so it may make sense to refinance even if you are only reducing your interest rate by a relatively small amount. There have been periods when the rates were dropping, where I refinanced the same customer 3 times in a year, and they benefited more each time. Let me work through the math to show you how this works.
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 $200,000 balance and a 6.75% interest rate with a payment of $1,297 per month. Let’s say that rates have improved, and you can now get the same type of mortgage for 6.00% with a payment of $1,199 per month. This is a savings of $98 per month. Does it make sense to refinance? Maybe. We still need to know more, though.
The next thing you need to know is how much it will cost to refinance. This is where it gets interesting. If you have spent any time on the internet, you have surely seen lots of ads for mortgage companies claiming they offer the lowest rates. The rates can be extremely attractive, but you need to look at the closing costs, also. I’ve seen closing costs vary by as much as $6,000, so this is something that can make a huge difference. 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 or upfront financing charges.
To see how the closing cost can make the difference, let’s assume that the cost to refinance is $2,000. If you are saving $98 per month and it cost you $2,000 to close, that means it will take you just over 20 months of mortgage savings to pay off the cost. Every month after that will be a true savings. If that same loan cost $6,000 to close, then it would take nearly 60 months before you would have any benefits from refinancing.
The next part is knowing how long you expect to be in the mortgage. If you plan to stay in the home for at least 10 years, and you don’t expect that interest rate will drop much lower than they are, then paying more to get a better rate may be the best strategy. Most people will either move or refinance sooner, though. The average 30 year mortgage is paid off in about 5 years. If you are like most people, you would be better served by getting a loan with lower closing costs and, even though the rate and payment may be a little higher, your savings will come quicker.
We have many options for low cost refinances including loans with no closing costs at all. In this case there is no pay back period and your savings start with your very first payment.
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