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.
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.
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?
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