I've had a couple of recent posts about mortgage refinancing, and I promised some instruction on how to crunch your own numbers to see if it's a good deal for you. Some lenders will be up-front with you and tell you that it's not worth it to refinance; others will not.
WARNING — LOTS OF MATH!
Generally, refinancing is a good deal only if you can save a substantial amount of interest during the time you'll keep the mortgage, and only if you can “pay back” the cost of the refinance quickly enough — and, as I found out, refinances are quite expensive — at least a few thousand dollars.
If you cannot get a much lower interest rate than you have now, it isn't worth it to refinance.
If you can, there are a bunch of options.
Let's say you're five years into a $200,000 mortgage at 30-years fixed with 7%. Your principal and interest payment is $1330.60 and you owe $188,263.54.
How did I figure this out? I went to Bret Whissel's Amortization Calculator and plugged in 200000.00, 7, 12, and 360 for principal, rate, payments per year, and number of payments, respectively. I also checked the “Show Amortization Schedule” button. I scrolled down to payment 60 (five years) and checked it out.
Now, this assumes that you've made the standard payment for the whole time. (We have on ours.) If you have been paying off the principal faster, then you can take your current loan balance, your current rate, your number of payments per year, and your payment amount (which is higher than what it should be), and leave the number of payments blank. You'll get the amortization schedule if you continue your current payment schedule.
OK — print this one out.
Now you can play around with the calculator. I've printed out a new amortization table with a starting balance of $188,263.54 and 300 payments left (I've made 60 payments). The P&I payment comes out to $1330.61 (close enough).
Say in the example above you can get down to 5.5% for 30-year fixed. (The lender would tell you this.) You can plug these numbers in — $188,263.54, 5.5, 12, and 360. You get a lower payment — $1068.94. Over $260 less per month, and about $13,000 less in interest after five years! If you paid about $2500 in closing costs, then the refinance “pays itself back” in the first year in saved interest.
Let's say that you keep the same payment ($1330.60) with this new rate. (You could afford it before, so why not now?) At the end of five years, you owe about $15,000 less than if you hadn't refinanced, and about $18,000 less than if you had just made the standard payment on the refinance! Good deal.
Or try a shorter term for the amortization. Maybe you can get 5.25% with a 20 year. Your payment's still less than it was before ($1268.60) but you'll be paying off the loan faster. You can typically get a lower rate with a shorter-amortization loan since they're less risky for the lender. However, the shorter term increases your payment (and locks you in to a higher “minimum payment”).
One last thing to try is “buying down the loan.” You can pay extra points (one point is 1% of the amount borrowed) at the onset of the loan to “buy down” the rate. I saw around a 0.25% rate reduction per point; the lender can tell you what the buy-down will get you. You'll save interest in the long run because of the lower rate, but you'll be out the extra money initially since it's an up-front cost. So, if we buy down the 30-year fixed rate from 5.5% to 4.75% with three points ($5,647), your payment would be under a grand, but you'd be out $8,000 in fees at the beginning.
The break-even point occurs when you recover the cost of the refinance in terms of the amount you owe on the house, compared to what you would owe if you hadn't refinanced. If you amortize these refinancing costs (thereby increasing your loan balance by a few thousand dollars), then the test is easy — you'll break even when the loan balances match up. If you don't, then your loan balance will be at break-even when the refinanced loan balance plus the closing costs equals the original loan balance. Beyond this time, your refinance should “pay off” meaning your loan balance should be lower than if you hadn't refinanced.
The above holds if you keep the same payment with the refinance. If you increase your payment in the refinance, you should take this into account by seeing where you'd be with the same increased payment without the refinance. So if I increased my payment to $1500 in the refinance because I shortened the term to a 10-year mortgage, I should see where I'd be with a $1500 payment on the original loan to see where the break-even point is.
If you really want to get fancy, you can take into account lost interest from the money that you use to pay for the refinance, and reduced federal income tax deductions because you're paying less in mortgage interest. I didn't do this, figuring that it would be less than $100 per year.
The main point? You can play around a lot with “what-ifs” to see whether refinancing is a good deal for you. One lender basically steered me away from refinancing because it took too long to break even. After crunching the numbers, I agreed with him.
