Knowing When to Refinance Your Mortgage

Refinancing a home loan can offer a number of advantages in certain situations, but it can also be risky and it is possible to loose money if you are not careful. It is also not free, as it is necessary to pay closing costs, similar to those paid when the mortgage was first taken out. Knowing when to refinance and when not to is therefore extremely important.

Determining if the Time is Right to Refinance

Typically, the golden rule in the real estate industry is that you should wait until the interest rate is at least 2% lower than your current rate before refinancing. It was often referred to as the 2% rule and was touted by most financial professionals, with the belief that this was the point where the savings outweigh the costs of refinancing.

However, today, most financial advisors will not recommend that you follow the 2% rule, primarily because the math simply does not add up. It certainly works well for the lenders, but it does not help the consumer.

Instead of only focusing on interest rates, it is instead essential to take into account the closing costs associated with the loan. This includes not only whatever points you are paying the lender and their application fee, but also an appraisal, credit report, title insurance, and attorney fees.

Practical Example: When to Refinance

As an example of how to evaluate whether refinancing lets say that under the new loan, your interest rate would be $50 less a month and the closing costs would be $9,000.

To determine if you should refinance, divide the closing costs by the amount saved in monthly payments. This will tell you the break even point, or when you will recoup your closing costs.

$9,000 / $50 = 180

So, in 180 months or 15 years, you would break even. This makes it easy to see that refinancing is not such a good idea.

Now, lets say that your closing costs are only $4000 and you save $100 a month.

$4,000 / 100 = 40.

So, in 40 months or 3.3 years, you would break even. This is much more acceptable, because this means that after three years, you will have saved more than your closing costs and will end up dramatically reducing the amount of interest you pay.

How Long is Too Long When Breaking Even

There is no set limit of when the break even point is right and when it is wrong. A great deal of this depends on the income, assets, and personal situation of the lender. However, usually if the break even point is less than 4 years(48 months) it is generally a good investment.

When to Refinance the Term

The above examples described when to refinance the interest rate, but sometimes it is a good idea to refinance the term. The term refers to the total length of the loan and is usually 30 or 15 years, although lenders offer mortgages of almost any term.

Generally, shorter terms mean a lower monthly mortgage payment and longer terms means a lower monthly payment. However, even though you are paying more each month with a shorter term, the amount of interest paid is almost always lower.

For example, consider a home that is $100,000. If you were to take out a 30 year fixed rate mortgage at 4.5%, your monthly payments would be $506 and you would pay $82,406 in interest over the course of the 30 years.

If, on the other hand, you took out a 15 year loan with that same interest rate, the monthly payment would be $764, but the interest would be only $37,698.

As a result of the dramatic effect lowering the length of your term can have on the total amount of interest paid over the course of the loan, it is sometimes a very prudent investment.

Often, many people will refinance their loan after about 5 or 10 years, to a shorter term, thereby saving a great deal of money.