The number-one refi mistake and how to avoid it
January 11, 2018
When you’re thinking about refinancing your mortgage, the decision comes down to one question: How much money will you save? And here’s the thing: refinancing at a lower interest rate doesn’t necessarily save you money.
That’s right! By far the most common mistake homeowners make is refinancing at a rate that’s not enough below their current rate to make refinancing worth the closing costs.
The numbers can be deceptive
The lower monthly payment that usually comes with a refi makes it look like you’re saving money, but it doesn’t always equal lower costs overall. In fact, you could be spending more over the life of the loan.
So how do you know if you should refinance? Below are four questions that will help you find your true bottom line. Remember, the decision ultimately depends more on your individual situation than on the market. If your best course of action still isn’t clear, a homeownership advisor can help.
Four questions to find your bottom line
How long will you live in your home?
This is important because you need time to recover the closing costs. They vary from state to state, even city to city, but you can usually expect to pay at least $2,000 (that figure can be quite a bit more in premium markets, for example San Francisco). The break-even period is usually at least two years.
A refinance calculator will help you determine the minimum payback period. Check out the ones at Bankrate and Ally. They take different approaches, so you might find it worthwhile to try both. But here’s some quick math, just for example:
Let’s say that five years ago, you closed on a 30-year mortgage for $150,000 at a fixed rate of 6.0%. Now you’ve prequalified for a 30-year fixed rate mortgage with a 5.0% interest rate. The closing costs for the refinance are estimated at $3,125. How long it will take you to get that back?
For simplicity’s sake, let’s do the math using the current monthly payment for principal and interest only (no taxes, no insurance): $900.
Step 1: Current payment – New payment = Monthly savings
$900 – $805 = $95
Step 2: Closing costs ÷ Monthly savings = Months to break even
$3,125 ÷ $95 = 33 months
In this refi scenario, then, it would be almost three years before you got back the closing costs. If you expected to stay in your home longer than that, the refi might make sense.
Keep in mind, though, that this level of calculation gives you a minimum payback time. To refine your numbers, read on.
How do the amortization schedules compare?
If the minimum payback period you calculated above makes sense for your situation, then try doing a more complicated, more precise calculation of the true cost of refinancing: compare the remaining amortization schedule of your current mortgage and the amortization schedule of the new mortgage.
If you’re going to pay the closing costs out of pocket, subtract that same dollar amount from the principal balance of your current mortgage. Why? Because you could put that money toward principal instead of toward refinancing.
Next, subtract the total amount you’ll save on monthly payments from the principal of the new mortgage. Similar idea as above: without the refi, you would be paying that toward principal.
The month in which this modified principal is less than the principal owed on the old mortgage is the true payback period.
Yeah, this is kind of complicated for some of us. It’s explained in more detail at Investopedia.
What’s the total payoff amount?
What’s left on the old mortgage the month before you close on the new one versus the total payoff amount of the new loan? The old amount will be higher by that month’s interest, but any higher and you’re increasing your total payoff amount — i.e. the total cost of your home.
What are the long-term costs?
If you’re 5 years into a 30-year mortgage, for example, you’ve paid a lot of interest but not much principal. If you refinance with a new 30-year mortgage, you’re starting over with almost as much principal as before, which can wipe out the benefit of the lower interest rate. The loan might even cost you more in the end.
If you can’t afford the monthly payments on a typical 15- or 20-year term, ask your lender for a custom term that matches the years left on your old loan. That way, you won’t lose the progress you’ve made.