How to Truly Know if You Should Refinance Mortgage

Many people understand that the decision to refinance involves more than just how much money they will save on a monthly basis. They also understand that there is value to the length of time they’ve being paying down their mortgage, but they don’t how to quantify that and determine if refinancing makes sense for them. Today I will show you how!

In order to consider if refinancing makes sense for you, there are two components that you must consider.

Calculate Your Monthly Savings

 

First, you must determine how much you will save on a monthly basis. This is relatively straightforward. You essentially just calculate what your new payment would be if you refinanced and subtract it from your existing payment. The difference will be your monthly savings.

Many people fall into the trap that this is the only thing you need to consider when refinancing. They divide their monthly savings into the amount it costs to refinance. This tells them how many months it will take to recoup their costs and as long as they will be in the house for at least that amount of time, they deem that refinancing is a good idea. But that would be a big mistake! This is where the second component comes in.

Recognize There is Value in Your Existing Mortgage

 

It’s really hard for people to refinance their existing mortgage if they’ve been paying on it for awhile – even if they will be getting a much lower rate and significantly reducing their monthly payment. This is completely understandable and their instincts are telling them that there’s a value to all those payments they’ve been making over the years. But how do you quantify that?

The second thing to consider when determining whether to refinance is that you must recognize there is value to the length of time you’ve held your current mortgage. Each and every month that passes, more of your payment is going towards principal and you’re building up equity at a faster rate. This is why it’s so hard to part with your current mortgage.

To quantify the value of your existing mortgage, you must calculate the loan balance for both your original mortgage and the refinanced mortgage over various time periods (i.e. 1 year, 2 years, 3 years, etc…). Then you subtract the two from each other at each time period. The result will show you whether you have more equity with the original mortgage or with a refinanced mortgage. For example, if at the end of year two, the loan balance on your original mortgage is $148,000 and the balance on the refinanced mortgage is $150,000, this shows that you will have $2,000 more in equity ($150,000 – $148,000) by keeping your original mortgage. But just like in the first component, you can’t look only at this one factor.

You Must Combine Both Components

 

To make an effective decision about whether to refinance, you must combine both components together – monthly savings and equity differential.

Let’s look at an example.

Let’s assume that your current 30-year mortgage balance is $250,000 (original balance of $300,000 taken out 8 years ago) with a 3.75% interest rate. This results in a monthly payment of $1,389. If you refinance to a new 30-year loan at 3.25% (which is the going rate at the time of this writing), then your payment will reduce to $1,097 per month; a savings of $292 / mo ($3,500 / yr). This is the first component and the advantage obviously goes to refinancing. But wait….

At the end of one year, your mortgage balance on the original loan would be $242,000 and $247,000 on the refinanced mortgage. This produces an excess equity of $5,000 ($247,000 – $242,000) by staying with the original mortgage. This is the second component and the advantage goes to the original mortgage.

When we combine the two components, we see that after one year, staying with the original mortgage produces a $1,500 advantage ($5,000 – $3,500). So in this case, if you plan to move before one year then don’t refinance.

As we look at the other time periods, we discover that refinancing only makes sense if you’ll be in the home for at least 3 years. In other words, refinancing puts more money in your pocket after 3 years. This is the true breakeven period.

This also goes to show you that rules of thumb such as “refinancing only when you can reduce your interest rate by 1% or more” should be thrown out the window. We’ve seen situations where reducing your interest rate by only a small amount can make refinancing a really good idea, especially if you reinvest your monthly savings.

Conclusion

 

As you can see, it’s important for you to base your refinance decision on both the savings you will achieve as well as the rate at which you will be building up your equity under both the original and refinanced mortgage. This is far superior than focusing on just one aspect.

Hopefully you’ve found this content helpful and feel more informed about whether or not you should refinance. Please feel free to leave any questions or comments below.

Brad Tinnon
CERTIFIED FINANCIAL PLANNER™

 

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