Most people have heard the old rule of thumb that it takes a 1% drop in your interest rate before a mortgage refinance is the smart play. This rule has been passed on by countless personal finance experts over the years.

I don’t want to call this advice dumb. Let’s just call it simplistic. Maybe it caught on because it’s easy to remember. Or maybe it’s just so simple that people tend to pass it on as sage advice. It’s not. In fact, there are times when a refinance makes perfect sense even if the rate is going up, not down. For example, if someone has an adjustable rate mortgage that carries long-term risk, it might make sense to accept a higher rate on a new loan. Some people refinance from a 15-year to a 30-year term due to changes in income and the resulting cash flow crunch. Other people might need to refinance due to a divorce situation or to get a non-occupant co-borrower off the mortgage. You get the picture.

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## Should I Refinance My Mortgage?

Those are specific instances, all with legitimate reasons to accept a mortgage with a higher interest rate than the current mortgage carries. But what if you are simply trying to assess whether or not to refinance based purely on the economic benefit derived from a lower rate? Here are the things you need to know to make a sound choice.

- Your personal plans for the property
- The current rate on your mortgage
- The new rate on the proposed mortgage
- The amount of the new mortgage
- The total net closing costs

Let’s start from the top.

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## Your Personal Plans for the Property

How long are you going to keep the property? Do you have plans to sell it within a few years or less? Will there be a reason to do another refinance during a similar time period? If the answer to either of these questions is yes, it may make more sense to either just hold on to the mortgage you already have or to consider an adjustable rate mortgage, which can result in a much lower rate than a fixed rate does. If you are going to dump the property within a year, you will have a hard time recouping any closing costs you incurred in the refinance. If you are not sure, however, you may want to hedge your bets by planning for the long term just in case.

## The Current Rate on your Mortgage Versus the Proposed New Rate

These figures will help you determine how much money you can potentially save through a refinance to a lower rate. Forget about that 1% figure for now. I will show you how to calculate your own scenario.

### The Amount of the New Mortgage

You will need this number in order to calculate the monthly savings in interest from the switch to a lower rate. Here is an easy formula:

(Old Rate – New Rate) /12 x Amount Owed / 100 = Monthly Savings

Here is an example. Let’s say you are refinancing a $250,000 mortgage from 5.5% to 4.75%.

5.5 – 4.75 = .75

.75 / 12 = .0625

.0625 x $250,000 = 15,625

15,625 / 100 = 156.25

Your monthly interest savings would be $156.25 on this loan.

### The Total Net Closing Costs

When you have the total net closing costs, you can then compare these costs to the monthly interest savings from the new loan and get an idea how long it would take to pay off the costs of the loan.

Please note that I said *net* closing costs. Here is a tip for you loan shoppers. Don’t ask your loan officer “how many points” there are on the loan or what the origination is. That is so 2006. I guarantee that you will not get the same answer out of different loan officers for the exact same quote. This is because the rules have changed. You need to get your mind off points and origination fees and on to net closing costs. There are a lot of things that go into closing costs, and some of the points are actually credited back to you in the transaction. The only thing that matters is what the actual costs are to you after all the calculations have been completed. You can end up with a no-cost loan that has three origination points in this new world. If you focus your attention on the wrong things, you may end up paying more.

The Loan Estimate is a form that provides you about some important details for the loan you’ve requested. This form will provide you several pieces of information, including the estimated interest rate, monthly payment, and total closing costs for the loan. It will also give insight into the estimated costs of taxes and insurance, as well as how the interest rate and payments may change in the future. It may additionally let you know about other special features of the loan, like penalties for paying off the loan early or increases to the loan balance even with on-time payments.

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To further see what the loan will cost you, you may want to check out a closing cost calculator such as this one.

Going back to our example above, let’s say the net closing cost is $3,500 for this loan. We have already calculated our savings from this new loan to be $156.25 per month. If you divide the closing costs by the monthly savings, you will have a figure that represents the number of months it takes to pay off the cost. That is your break-even point on this loan.

$3,500/$156.25 = 22.4 months

I am sure that it is now clear to you why your plans for the home are an important part of your decision. In this scenario, if you plan on keeping this loan for two years or more, it probably makes sense.

If you spend enough time going over scenarios, you will soon find that the higher the loan amount, the less of an interest rate change is needed to make the numbers work.

After all, a mortgage is all about the numbers. Happy crunching.

*Have you recently refinanced? Any questions about this process?*

**Leave your comments below!**

## 7 Comments

Good article, most rules of thumbs are either useless (like the 2% rule) or overly simplistic as the rule you just described.

Good article, Mark. I would also add what are plans for buying another property. The refi will take a hard pull on your credit and can affect getting another mortgage.

Mark I have a question. This is an idea I explored when contemplating refinancing one of our mortgages a couple years ago. To be simple, if you refinance into a lower rate, you expect to have a lower monthly payment, right? Well If you at year 25 of your current 30 year mortgage, the new mortgage is re-set to 30 years. Which means you will be paying another five years (virtually all interest) to get back to year 25 of your new 30 year loan, right? So although you may be reducing your monthly payment, you are adding five more years to your current loan term. Five years which will almost entirely consist of interest. So, my thought is that refinancing your loan to take advantage of a smaller rate could potentially increase the overall money out of your pocket in the long run. I am not a finance guy, so please correct me if I am wrong.

Kyle,

There are 5 factors that go into how much you are going to pay over the life of a loan.

1) The total amount of the loan

2) The interest rate

3) The length of time you take to pay off the loan

4) The total amount you pay each month

5) When you make the payments (if you pay $100 in month 1 it will make a much bigger impact than in month 50).

If you decrease your interest rate and increase the amount of time you’re going to take to pay it off (keeping the total amount the same) then you could end up paying more total money in the long run depending on how much you decrease the interest rate and how much you increase you loan term. The flip side is that you decrease your monthly payment, so you increase your monthly cash flow. If you re-invest the extra cash flow then your amortization schedule won’t look too much different, but you gain some flexibility.

Its all in the numbers, and you have to evaluate what structure makes sense for you.

Bigger Pockets has a pretty convenient tool to quickly calculate what your monthly payment will be: https://www.biggerpockets.com/calculator-mortgage

You can also use the PMT(),PPMT(), and IPMT() functions in excel to pretty easily build yourself an amortization schedule calculator to see how varying the different factors can change the total amount you have to pay.

Thanks for the response ANANT. I too have an used a similar excel amortization sheet to fully explore the ramifications of the decision to re-fi or not re-fi. I understand your principles and was not arguing Mark’s discussion, just thought it be worth bringing up as I feel many consumers fail to consider this issue when contemplating a re-fi. Again, thank you for your response.

Hi Kyle, you’re definitely correct. When you refinance, you’re resetting the clock on your mortgage to day one. Your payment is going down in part because you’re stretching the loan back out over 30 years. If you really want to maximize the benefit of the refinance, keep making the same payment you were before. Because the interest rate on the new loan is lower, you should be able to pay off the mortgage much faster and for far less in interest.

BTW – I don’t think I can take 100% credit for this article. It looks like it’s been pretty heavily edited from the original version.

Great info and discussion. Thank you Mark.