Leveraging debt correctly can be the difference of hundreds of thousands of dollars in interest payments. A great way of doing this is by understanding how and when to refinance your loans.
Here's how to know if you should refinance your mortgage:
Refinancing your mortgage might not be one of the hottest topics in the personal finance world right now, but it might be in the next few years with all the people who got 5-7.5% mortgages over the past year or so.
Interest rates have gone up drastically, so it only makes sense to talk about refinancing so you can take advantage of this when the time comes. So what does it mean to refinance your mortgage?
Refinancing your mortgage is when you pay off your existing loan and replace it with a new one. Oftentimes people choose to refinance to:
- take advantage of lower interest rates
- change the terms in years of the mortgage
- or to tap into their home equity
In this blog post, we will focus on refinancing due to interest rate changes.
To determine whether you should refinance is not as simple as comparing the previous monthly payment to what the new one monthly payment would be if you refinanced. You need to understand all the costs associated with refinancing and whether or not it will lead to savings for you.
The factors you need to know are:
- the amount of time you will live in the house
- the closing costs to refinance
- the new interest rate
- and what the new monthly payment will be
Once you know all of these factors, then you can determine what is the most beneficial for you. To make the best decision follow the equation below.
Closing costs / monthly savings = Breakeven timeIf breakeven time > time planned to live there…Then you
do refinance.
If breakeven time < time planned to live there…Then you don't refinance.
Here’s a couple examples to help illustrate if you should refinance:
Kayla and Adam have the current situation:
- Current Interest Rate: 7%
- Current Monthly Payment: $4,000
- New Interest Rate: 5%
- New Monthly Payment: $3,200
- Closing Costs: $6,000
- Monthly Savings: $800
Time planned to live there: > 120 months
Note: If you don’t want to do the math by hand, bankrate has a great calculator for thisIf they were to refinance their home, they would save $800 /month in savings.
However, to determine if it is in their best interest to refinance you need to factor in the closing costs. With $6,000 of closing costs, they would need to live in the house for at least 7.5 months for it to make sense ($2,500 / $180 per month = 13.89 months).
7.5 months < 120 months
Since they plan to stay in their current home for 10 more years, they should refinance. It would result in savings of $800 every month after the breakeven point. I don’t know about you, but most would love to have an additional $800 in their budget. It is also important to note that you can roll these closing costs in as well.
Let’s look at another example to help reinforce the idea.
Alex and Tara have the following situation:
- Current Interest Rate: 6%
- Current Monthly Payment: $3,000
- New Interest Rate: 5.5%
- New Monthly Payment:$2,800
- Closing Costs: $4,500
- Monthly Savings: $200
- Time planned to live there: 18 months
Following the same principle in the previous example, If Alex and Tara were to refinance they would save $200 a month, but you have to factor in the closing costs again.
Based on a $4,500 closing cost, it would take 22.5 months to hit a breakeven point ($4,500 / $200 per month = 22.5 months).
22.5 months > 18 months
Since Alex and Tara only plan to live there for 18 months, then they should not refinance. If they did, they would end up losing money in the long run which is definitely not the goal.
As you can see, the key to understanding whether you should refinance or not, is to find the breakeven point in months and then figure out if you plan to live in your house beyond that.
Because there are some grey areas where rules of thumb don’t apply, consult your financial advisor or loan officer to determine the best option for you. I know it can be hard to predict the future and know the amount of time you will live in your house, but just make the best guess you can. That’s all you can do. Once you know that, then you can determine whether you should refinance or not.
Hopefully this helps you understand the factors needed to evaluate whether it makes sense for you and your family to refinance! It is safe to say that it is something worth evaluating as it potentially could save you some money in the long run.
Financial Advisor