When you have a mortgage, you’ve committed to pay your lender a specified interest rate — or a variable interest rate — for a period of time. The only way this rate or period can change is by refinancing.
When interest rates go down, refinancing can mean essentially trading your higher-interest mortgage for a less expensive one. If you get a huge raise at work, refinancing can allow you to pay your mortgage off in 15 years instead of 30.
Sounds great, right? It is, sometimes. But, in certain situations, you may not save money by refinancing. In others, it may actually end up costing you a lot.
The catch with refinancing comes in the form of “closing costs.” Closing costs are fees collected by mortgage lenders when you take out a loan, and they can be quite significant. Closing costs can run between 3–6 percent of the principal of your loan. If you still owe $200,000 on your home when you refinance, you could pay $6,000–$12,000 in fees!
The decision to refinance comes down to this: Will the terms of your new loan definitely save you more than you’ll pay in closing costs?
Will a refinance actually save you money?
This is where we get into some number crunching.
Take the cost of the refinance — closing costs and any other fees your lender charges — and divide them by the amount of money that you will be saving each month as a result of doing the refinance.
Here’s an example:
Let’s say that you are considering refinancing your 30-year, $200,000 mortgage from a current rate of 5.50 percent to a new 30-year mortgage at 4.50 percent.
It will cost you $6,000 in fees. Your current monthly payment at 5.50 percent is $1,136, and the new payment at 4.50 percent will be $1,013. That will result in a reduction in your monthly payment of $123.
In order to calculate the refinance recovery period, divide $4,000 in closing costs by the $123 per month that you will be saving as a result of doing the refinance. In this case, the recovery period will be roughly 49 months.
As long as you plan on staying in the home for more than 49 months — or a little over four years — the refinance will save you money.
Be careful when refinancing into a shorter term loan
When interest rates are low, there’s a strong motivation to reduce the term of your loan.
On paper, that makes perfect sense. But in my own time in the mortgage business, I saw a trend in which many of the people who refinanced a 30-year loan into a 15-year loan came back a year or two later and wanted to refinance back to a 30-year loan.
The reason for this is simple: As much sense as a term reduction makes, it results in a much higher monthly payment. Much higher.
Let’s look at another example:
Once again, let’s say you’re considering refinancing your current 30-year, $200,000 mortgage at 5.50 percent into either a 30-year loan at 4.50 percent or a 15-year loan at 4.25 percent.
How do the payments look?
- 30 year at 4.50 percent: $1,013
- 15 year at 4.25 percent: $1,505
- Difference: $492
As you can see, the difference between the 30-year payment and the 15-year payment is substantial, despite the fact that the 15-year loan actually has a slightly lower rate of interest. The 15-year loan is certainly the better choice from a long-term financial standpoint, but can you afford to pay nearly $500 extra each and every month? That’s almost $6,000 more per year for the next 15 years.
You can use our mortgage calculator to run your own numbers.
A lot of homeowners are not aware of how much of a burden that extra expense will be until they actually get into the loan and start making the monthly payments.
Get the best deal possible
The amount you pay each month depends on the deal you get when you sign on the dotted line. Even small savings on interest can pay off over multiple months and years.
Figure offers competitive interest rates on mortgage refinance loans. The entire application process is online, making the process quick and convenient. You can calculate how much you’ll save based on the quote they offer, then decide whether it’s worth paying closing costs. Often a monthly reduction may not seem like much, but when you add it up over months and years you’ll be in your home, the savings are far more obvious.
The value of refinancing comes down to comparing the money saved in the long term to the fees paid out in the short term. The more confident you are that your current home will be yours for many years, the more you could save by refinancing to a lower rate.
Figure Lending LLC dba Figure. 15720 Brixham Hill Avenue, Suite 300, Charlotte, NC 28277. (888) 819-6388. NMLS ID 1717824. For licensing information go to www.nmlsconsumeraccess.org. Equal Housing Opportunity. Licensed in Alabama 22533, Alaska AK1717824, Arizona 0948458, Arkansas 114692, California: Loans are made and arranged pursuant to a Finance Lenders Law License, Licensed by the California Department of Financial Protection and Innovation under the California Finance Lenders Law (License 60DBO81967), Delaware 026994, Florida MLD1636, Georgia Residential Mortgage Licensee 61229, Idaho MBL-9625, Indiana 39933, Iowa 88893478 and 2018-0048, Kansas MC.0025537 and SL.0026703, Louisiana 1717824, Massachusetts Mortgage Lender License ML1717824, Michigan FL0021494, Mississippi 1717824, Missouri 19-2421, Montana 1717824, Nebraska 1717824, Nevada 4823, New Hampshire 22423-MB, Licensed by the N.J. Department of Banking and Insurance, New Mexico 1717824, North Carolina L-180811, North Dakota MB103310, Ohio RM.804317.000, Oklahoma ML011894, Pennsylvania 66882, South Dakota ML.05202, Tennessee 151185, Washington CL-1717824, West Virginia ML-36248, Wisconsin 1717824BA