You want to refinance, but is it worth it? Did you know that it takes more than determining if you can get a lower rate? A lot goes into the decision to refinance. If you aren’t careful, you could end up overpaying for a refinance or refinancing when it’s not necessary.
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So how do you know when refinancing will save you money? It’s all about the break-even point.
What is the Break-Even Point?
Your break-even point is when you start realizing the savings from refinancing. First, you have to cover the closing costs, then you realize the savings.
Paying off the closing costs in this regard is figurative. You aren’t literally paying anyone back. It’s just a measure of how long it would take you to recover the costs you paid for the loan to see if it makes sense to refinance. The break-even calculation is as follows:
Total closing costs/Monthly savings = Months to break-even
Now you take the months to break-even and decide if you will still be in the home long enough to enjoy the savings. Let’s say it would take you 4 years to recover the closing costs. Let’s also say that you will move in the next 3 years. It obviously doesn’t make sense to refinance. Even though you may have a lower payment, you’ll still pay more in the end.
Look at the Big Picture
Deciding if you will save money when refinancing isn’t just about looking at the monthly payment, you also need to look at the big picture. You should total up the closing costs and the interest over the life of the loan to see the true cost of the loan.
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For example, let’s say you can lower your interest rate. You assume that you’ll save money because you have a lower payment. It makes sense, but once you dig a little deeper, you may find that you won’t save money. If you restart your loan term, you will pay the lower interest rate, but for a longer time. You just added months onto your loan term. If you add up the total cost of the interest over the life of the loan, you may see that the refinanced loan will cost you more in the end.
This means that you should ask your lender not only what your monthly payment is, but also how much the loan will cost at the end of the term. You can then compare it to what your current loan would cost at the end of the term. Are you saving money? Is it enough of savings to make it worth it?
Exceptions to the Rule
Now, these rules only apply if you have a fixed-rate mortgage now and are refinancing into another fixed-rate mortgage. If you have an ARM or interest-only loan now and want to refinance, the break-even point may not help.
In these cases, it’s all about getting a steady and predictable interest rate. There’s something to be said about predictability. You’ll know what your mortgage payment is each month and you won’t have to worry about it adjusting or being unable to afford your mortgage payment. In these cases, you just have to use your common sense. Is the payment more affordable? Is the interest rate along the same lines that other lenders would charge? Are you taking the shortest term that you can afford?
These are questions you should ask yourself. Remember, if you can afford a shorter term, you’ll minimize the total cost of the interest that you pay. If you take another 30-year term, it’s like the years that you already paid on your loan disappear. You start from ground zero – is that where you want to start?
Refinancing your mortgage can save you money, but only if you choose the right loan. Don’t get caught up in interest rates and forget about the closing costs and the total cost of the loan. Look at the big picture to decide what loan will work best for you.
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