Should you refinance your mortgage? Depends on breaking even.
With mortgage rates at record lows, refinancing your mortgage right now might seem like a no-brainer. And for millions of American homebuyers, that certainly may be the case – in fact, I’m currently shopping around for a refinancing loan for my own home.
However, there’s more to consider when it comes to refinancing than just the interest rate you can get on a refinancing loan. Here’s an overview of how to tell if refinancing could be worth it for you, as well as some of the other factors you should consider before filling out an application.
Is refinancing worth it? The 30-second calculation
The key point to know before you start the mortgage refinancing process is that refinancing isn’t free. Lenders charge origination fees when you want to refinance, and there are also several other common types of closing costs like title insurance, appraisal fees, and credit report fees. These can vary dramatically: The cheapest option I found in my recent refinancing application came to about $1,600 to close.
So the key question to ask is whether the savings you achieve on your monthly payment will justify what you’re paying to refinance. This is known as the breakeven calculation, and here’s how it works:
- Take your current monthly mortgage payment (just principal and interest) and subtract what your new mortgage payment would be if you were to refinance. When you obtain rate quotes from mortgage lenders, they should provide you with this information. This will tell you how much you could save per month by refinancing.
- Next, take the total closing costs of obtaining the loan, including origination fees and any other charges you might need to pay, and divide it by the monthly savings you found in the previous step. This tells you the number of months until your refinancing achieves its breakeven point.
Here’s why this matters: If you’ll live in the home for longer than it takes to break even, refinancing could be a smart idea. If not, it’s probably best to stick with your current mortgage.
It’s also worth noting that you can perform this breakeven analysis several times if you shop around for more than one rate quote for refinancing (which you should certainly do).
An example of the breakeven calculation
Let’s take a look at how this works. We’ll say that you still owe $250,000 on your mortgage and that you’re currently paying $1,325 per month for principal and interest. You obtain a quote to refinance into a new 30-year fixed-rate mortgage at an APR of 2.875%, and this would result in a monthly payment of $1,038. However, it would cost a total of $3,600 to close on the loan.
To calculate the breakeven point, first subtract the new mortgage payment of $1,038 from the current $1,325 monthly payment, a difference of $287.
Next, divide the $3,600 in closing expenses by $287, which gives you 12.5. (Note: Always round this up to the nearest whole number.)
This tells us that our refinancing savings will outpace the cost of obtaining the loan in just 13 months. That’s why this is such a good environment to refinance a mortgage for so many people.
Other factors to consider
In addition to the breakeven analysis, there are a few other things to consider before deciding to refinance:
- Loan term: When most people refinance, they generally obtain a new 30-year loan. If you’re using a refinancing loan to replace a mortgage you’ve been making payments on for years, keep in mind that you’re effectively restarting the clock, and it could take years longer until you own your home free and clear.
- Cash-out refinancing: If you have substantial equity in your home, you may be able to take some cash out of your home when refinancing. If you have credit card debt to consolidate, have home improvement projects to complete, or otherwise need a substantial sum of money, this can be an extremely cheap way to borrow.
- Eliminate PMI: If you’re paying private mortgage insurance (PMI) and the value of your home has increased since you bought it, you may be able to eliminate it by refinancing. If this is the case, it should definitely be considered in your breakeven analysis when comparing your mortgage payments before and after refinancing.
The bottom line on refinancing
There’s no one-size-fits-all answer to whether you should refinance. But if you use the breakeven calculation above and take some of the other potential reasons to refinance into account, you’ll be in a good position to make the right decision for you and your family. And with mortgage rates at all-time lows, if refinancing makes good financial sense for you, now could certainly be a smart time to do it with the right refinance lender.
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