Refinancing doesn’t automatically mean you’ll save money. You have to find what is called the break even point. You might be surprised to learn just how long it takes to actually save money on a mortgage. This is why we constantly say not to focus on the interest rate. Too many people jump at the chance to get a lower rate.
Sometimes that lower rate doesn’t really pay off. It’s all in the details.
We help you figure out those details below.
How Much Will You Pay for the Loan?
First, you should figure out
what the refinance costs you. It’s not free. Unless you negotiate a no-closing cost loan with your lender. If you do, though, you’ll pay a higher interest rate. There might not be a point in refinancing if that happens.
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So back to square one – you pay closing costs. How much do you pay? This is the important question. Sit down and look at the Loan Estimate. Then be honest with yourself about what the loan will cost you. If you find that one lender’s closing costs are too high, shop around. You can then compare Loan Estimates to find the refinance that is right for you.
Some of the most typical closing costs include:
- Lender fees – Processing, underwriting, and document fees are pretty standard. You may also pay points or discount fees to get the rate you want.
- Third party fees – Appraisers, lawyers, and even credit reporting agencies will charge for their services.
- Title company fees – You’ll likely need a title search and a closing agent, both of which cost money.
These costs add up. They take away from your savings. Given the right circumstances, though, you can make that break even point as short as possible.
How Much Will You Save on the Loan?
Now comes the fun part. How much will you save? You can figure it out by looking at your current and potential mortgage payment. Don’t get too excited just yet, though. You won’t realize those savings until you hit the break even point.
In other words, you need to reap the savings to make up for the costs of the loan. For example, if you paid $4,000 in closing costs, you’d need to make up that $4,000 month by month with your new lower monthly mortgage payment.
Figuring out how much you’ll save is important. Make sure you only look at principal and interest. Don’t figure in your taxes and insurance. Those are constants that won’t change whether you refinance or not.
Calculating the Break Even Point
Now that you have this information, you can figure out your break even point. Take the total costs and divide it by the monthly savings.
For example, let’s take the $4,000 in closing costs, but say you’ll save $150 per month on your mortgage payment. Your break even point would be:
$4,000/$150 = 27 months
This means you’d have to stay in the home for at least 28 months to realize the savings.
The next step is figuring out your future plans.
Why the Break Even Point Matters
Figuring out your break even point helps you
determine if it makes sense to refinance. Using the above example of 27 months, let’s say you plan to move in 2 years. It wouldn’t make sense for you to refinance. It would end up costing you more out of your own pocket than you would save in the end.
Now, if you planned to stay in the home for the next 10 years, you’d definitely benefit from refinancing. You’d have 93 months with a savings of $150. That’s a total of $13,950!
Going Beyond Break Even and Saving More
Now, it’s possible to take it a step further. Let’s say you originally had a 30-year mortgage. You already paid a few years on it. You don’t want to refinance into another 30 year loan. That’s like losing the last few years of payments.
Instead, you opt for a 20-year loan because rates dropped and you can afford it. Now you’ve knocked off 10 years off your loan. That 10 years could mean thousands of dollars in interest.
Even if you can’t take out a shorter term, you can still enhance your break even point. Rather than banking the money you save on your new mortgage payment, put it towards your principal. That extra payment every month will consistently knock down what you owe. It will cut years off your loan’s principal. This translates to much less interest over the life of the loan.
It All Comes Down to the Reason for Refinancing
In the end, it depends on why you want to refinance. Not everyone refinances to save money. Some do so to tap into their home’s equity. Others do it because they want to snag a lower interest rate or change their loan’s term.
Sometimes the break even point doesn’t matter if the new mortgage will benefit you in some other way.
Before you refinance, figure out your reason. Then look closely at the break even point. Does the refinance benefit you? Will you be in the home long enough to realize the benefits? Sometimes rather than refinancing, you can just make extra payments as you can afford them. Of course, if you stand to obtain a lower interest rate, it could help, though. Saving thousands of dollars in interest could help you when you reach closer to retirement age.
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