Owning a home is a huge expense. When you have a mortgage, you’re likely to spend tens of thousands of dollars in interest. If you’re not happy with your interest rate, you could consider refinancing your mortgage to get a lower rate and save money.
Kiplinger forecasts an increase in mortgage rates by the end of 2017. If you already have a mortgage, now might be a good time to refinance before rates rise.
How to find your breakeven point
However, the decision to refinance isn’t always as simple as finding a lower interest rate; your breakeven point also plays a big role in the process. Your breakeven point is the amount of time it takes for your interest savings to outweigh the cost associated with refinancing a mortgage.
Consider your breakeven point to help you decide if refinancing a mortgage is worth it. Here’s how to calculate your breakeven point:
Step 1: Find out how much money refinancing will save you
Your first step to figuring out your breakeven point is to find out how much refinancing could save you.
Let’s say you have a mortgage balance of $190,000 with a 4.8% interest rate. You have 25 years left on the mortgage, but you decide to refinance to a 30-year term at 3.78%. Using our mortgage calculator, you can see the results:
In that scenario, you could save $206 per month by securing a lower interest rate and extending your repayment period by five years.
If you end up working with a lender that offers no closing costs for your refinance, consider yourself lucky — you don’t have to worry about a breakeven point. In that situation, your breakeven point is immediate because you don’t have to put any money down to refinance.
Step 2: Figure out the fees
Most people who refinance their mortgage will have to pay fees. Real estate website Trulia points out that you are likely to pay the following fees when refinancing a mortgage:
- Loan origination fee: About 1 percent of the balance of your loan
- Mortgage application fee: $250 to $500
- Appraisal report: $300 to $600
- Document preparation fee: $200 to $500
- Title search: $200 to $400
- Title insurance: $400 to $800
- Recording fee: $25 to $250
Using our example of a $190,000 mortgage balance, your loan origination fee would be $1,900. Add that to the lowest estimate of the other fees on the list, and the total cost to refinance your mortgage would be about $3,300.
To find your breakeven point, divide your total closing costs by your monthly savings. In our example, you would divide $3,300 by $206 to get 16.02. That means your breakeven point would come about 16 months after you refinance your mortgage.
As long as you plan to stay in your home for another year and four months, you will break even on your mortgage refinance.
Step 3: Consider your LTV
Fees aren’t the only thing to consider. Before you complete your refinance, your home will likely be appraised. In that case, your loan-to-value (LTV) ratio matters.
Your LTV represents how much you owe on your mortgage in relation to your home’s market value. If your LTV is above 80 percent, you might be required to put some cash down to refinance.
If you haven’t been in your home very long (in our example, you’ve only owned the house for five years), you might not have had time to build proper equity. Even if you put down a large down payment or have been in your home for longer, you might have a high LTV if your house lost value.
Let’s say you originally bought your home for $225,000. You made a down payment of $15,000, so your original mortgage was for $210,000. Since you bought your home, it has increased in value to $230,000.
An LTV of 80 percent is figured by multiplying 0.80 by the appraised value of the home ($230,000). The result is $184,000 — this is the amount a refinancing lender would be willing to give you.
However, after a few years of payments, you still owe $190,000 on your original mortgage. In order to refinance, you’re required to come up with $6,000 in cash.
The good news is that this slightly changes the calculations, since you will borrow less money. According to the calculator, refinancing with the above numbers would save you $234 every month.
This scenario also gives you a new breakeven point. It cost you an extra $6,000 in cash to refinance, so you must add that to the $3,300 of closing costs from step two.
Now your total costs to refinance your mortgage are $9,300, making your breakeven point 39.74 months. It will take about three and one-third years to reach that breakeven point.
Step 4: Decide whether or not to pay points
Finally, you have to consider whether or not it’s worth it to pay points when you refinance. This will increase the amount you pay out of pocket, and it will take longer to reach your breakeven point. However, paying points decreases your interest rate, which could save you money in the long run.
Each mortgage point you purchase costs one percent of your loan amount and will reduce your interest rate by about 0.25%.
Let’s say you put $6,000 down to get to your desired LTV in the previous step and refinanced your mortgage for $184,000. Each mortgage point you buy will cost $1,840. If you pay for two points, it will cost you $3,680 and lower your interest rate by 0.5% to 3.28%.
That new interest rate would save you $285 every month compared to your original mortgage payment. However, if you do all the things in the previous step, your out of pocket cost to refinance your mortgage rise to $12,980.
Since it cost you more money to refinance, you have a new breakeven point. Now it will take 45.54 months, or a little more than three years and nine months, to recoup your refinancing costs.
Should I refinance my mortgage?
There’s no simple answer to “Should I refinance my mortgage?” Whether or not refinancing is worth it depends on how much you can save with a new interest rate, as well as the costs you pay for your refinanced home loan. You’ll also need to decide if it’s worth it to put cash down or pay points.
In general, it makes sense to ensure that you’ll be in your home long enough to break even. If you plan on moving before you reach that point, it’s probably not worth the expense to refinance your home.