"Since it costs money out of my pocket to refinance, how do I know whether or not I will end up saving money?"
To save money, you must stay in your house longer than the "break-even period" – the period over which the interest savings just cover the refinance costs. The larger the spread between the new interest rate and the rate on your existing loan, the shorter the break-even period. The more it costs to obtain the new loan, the longer the break-even period.
But beware! The break-even period is not the cost of the new loan divided by the reduction in the monthly mortgage payment. This widely used rule of thumb is a misapplication of the principle that when explaining something to the consumer one should "keep it simple." Simple is good, except when it’s wrong!
The rule of thumb does not allow for the difference in how rapidly you pay off the new loan as opposed to the old one. Lets say that in 1992 you took out an 11% 30-year fixed rate loan, which now has a $100,000 balance and 21 years to run. You refinance into a 7% 15-year loan at a cost of $3,750.
Monthly payment on the old loan = $1019
Monthly payment on the new loan = $899
Reduction in monthly payment = $120
$3750 divided by $120 = 31 months
The rule of thumb says that you break-even in 31 months. However, because of the shorter term and lower rate on the new loan, in 31 months you would owe $7,041 less than you would have owed on the old loan. So, the rule of thumb in this case seriously overstates the break-even period. Taking account of differences in the loan balance, you would actually be ahead of the game in 12 months, as shown below:
Savings in monthly payment: $120 for 12 months = $1440
Plus lower loan balance in month 12: $2620
Equals total saving from refinance: $4060
Less refinance cost: $3750
Equals net gain: $310
Next consider the case where an 11% loan taken out in 1992 was for 15 years, and now has only 6 years to run, while you plan to refinance into a 30-year loan. With the remaining term shorter on the old loan and longer on the new one, the difference in monthly payment rises to $1238. Using the rule of thumb the $3750 cost would be recovered in only 3 months. But this fails to consider the slower loan repayment on the new loan. Taking account of the slower repayment, you don’t actually come out ahead until 14 months out.
The rule of thumb (dividing the upfront cost by the reduction in mortgage payment) approximates the true break-even period only if the term on your new loan is close to the unexpired term on your old loan. In other circumstances it can lead you seriously astray.
The rule of thumb also ignores the fact that if you had not refinanced you could have earned interest on the money you pay upfront to refinance; and if you do refinance and the payment is reduced, you can now earn interest on the savings.
My calculator 3a allows you to take account of all the factors that affect the profitability of refinancing a mortgage. These include the time value of money, taxes, and differences in the cost of mortgage insurance between the old and new mortgage. This calculator assumes that you have only one mortgage and you don't take any cash out of the transaction. Other refinance calculators are available for borrowers who have a second mortgage or want cash from the transaction.
Copyright Jack Guttentag 2006
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