Refinancing your mortgage can be highly alluring, especially if you can find a lower rate. You might be able to reduce your mortgage's monthly payment, pay it off sooner, and perhaps even cash out some of your home's equity. However, closing expenses and other fees can soon deplete any savings you might have hoped to achieve, leaving you worse off than where you were before. Refinancing your mortgage makes sense in some circumstances. You can find those chances by using a little math.
Main points
- Your break-even point, or how long it will take you to recoup refinancing expenses, will determine the ideal timing for you to refinance.
- Before deciding to refinance, it is important to know if you will be able to afford a fixed-rate or adjustable-rate mortgage.
- Perhaps you can locate a loan with a lower interest rate and a shorter term than the one you have now.
- If you refinance, you might pay a few hundred dollars less each month, but you could end up paying tens of thousands more in interest over the course of your lifetime.
Establish your break-even point
A break-even point is one method for assessing refinancing. You may determine how long it will take to recover the costs of the refinance using this methodology. Consider the scenario where you spend $2,000 in closing charges and fees for a new loan and your new monthly payment is $100 less than it is today. ($2,000 in costs divided by $100 in monthly savings) needs 20 months to break even in this scenario. After that, you make $100 more each month. Divide your monthly savings by the refinancing fees to determine the break-even point. The following would be the written formula:The Formula for Breakeven
Your break-even threshold must be reached fairly quickly for refinancing to make sense. A shorter time frame allows you to enjoy the advantages for a longer period before you sell or refinance once more. Because you already know when you might sell your property, this calculation is useful if you intend to move. Closing costs for a refinance are typically between 3 and 6 percent of the loan's principal amount.Remember that costs and fees may differ slightly amongst lenders. When doing your calculations, be sure to take into account the possibility that they may alter from loan to loan with the same lender.Is it Possible to Switch Between a Fixed-Rate and an Adjustable-Rate Mortgage?
Changing from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage may make sense. Even if they begin lower than fixed-rate mortgages, ARMs may eventually have higher interest rates. When interest rates start to rise, the originally low ARM rates may cause higher monthly charges. Variable rate uncertainty can be removed by refinancing an ARM into a fixed-rate 15- or 30-year mortgage. If you have an ARM, switching to a fixed-rate loan when interest rates are low is an excellent idea. On the other hand, switching from a fixed-rate mortgage with a high interest rate to an ARM that takes advantage of decreasing rates may make sense when mortgage rates are falling (and you anticipate that they will continue to do so). Homeowners who can tolerate larger monthly payments in the event that rates rise once again are the greatest candidates for this kind of refinance. When deciding between a fixed-rate loan and an ARM, there is always a degree of uncertainty because the future cannot be predicted. Make sure you can afford larger payments if you choose an ARM, just in case.Are You Interested in a Shorter Mortgage Term?
By reducing the number of years you have to make loan payments, refinancing may help you pay off your house sooner. A shorter-term loan's lower overall interest rates is another benefit you can use. The interest on a mortgage spread over 30 years will be higher than that of a spread over 15 years. In this case, the interest alone on a $200,000 loan spread over 30 years at 4% will cost $143,739.Interest on the same mortgage over a 15-year period will cost $66,288. Refinancing to a loan with a shorter term makes sense if you're seeking a solution to reduce interest rates and pay off debt faster. Additionally, rates on loans with shorter terms are typically lower than those on loans with longer terms.Is There a Lower Rate?
Mortgage rates are continuously changing. Your credit score, the state of the economy, and the property you own are just a few of the variables that affect the rate you receive. You might save money by refinancing if the rate you were eligible for when you first bought your house was much higher than what you could get today. Although a lower interest rate is always welcome, make sure you still earn money after paying closing charges. Here are a couple techniques to do that:- Performing a break-even analysis as previously mentioned
- Considering the overall cost of lifetime income (see below),
Refinancing: Exercise Caution
Refinancing might not always be a smart move. For instance, occasionally, even if your monthly payment drops, your overall interest payments will rise. This is particularly true if you convert from a shorter-term loan to a loan with a longer term, such as when you switch from a 15-year loan to a 30-year mortgage. How this occurs can be demonstrated using an amortization table. A portion of each monthly payment you make is applied to the principal you borrowed, and a portion is used to pay interest. The process of paying interest on your earlier loan installments rather than principal is known as amortization. In the initial years of debt repayment, the majority of each payment goes toward interest; the principle is hardly touched. If you continue making payments on your previous loan, the loan sum will eventually be paid off entirely over time. However, if you refinance your previous loan and take out a new one, you return to the beginning of the amortization period and those initial payments, which are primarily interest charges. You would have to pay on your property for a total of 40 years if you had a 30-year mortgage, then refinanced after 10 years to another 30-year mortgage.