One of the most common questions that I hear on a regular basis is “How much should my rate drop in order to refinance my mortgage?” The short answer is that EVERY SITUATION IS DIFFERENT.
I have heard a lot of people suggest that you should only refinance if your rate descreases by 1 full percent or 2 full percent, but this is not necessarily the best advice. In many cases, if rates decrease by a full percent, it makes sense to take a closer look at refinancing – however, there are many factors to consider. If you’re thinking about refinancing, you’ll want to do a complete Break Even Analysis and determine exactly when the costs for the refinance will be recovered.
Determining the True Break Even Point in a refinance is generally determined one of two different ways. It’s best to look at them both and determine which makes the most sense based on how you will be repaying the loan and how long you plan on keeping the house.
1. The first method in determining when it makes sense to refinance is generally when you are refinancing for the sole purpose of lowering your monthly payment. You can take the total sum of the closing costs that you will be including into the new loan amount (or paying out of pocket) and divide this total by the amount of decrease in the monthly payments.
For example, if the closing costs (lender, title, recording, appraisal, and other applicable fees) total $3000, and you’re payment decreases by $150 per month, then it will take approximately 20 months to break even.
Note – If you’re rolling in the closing costs, you should pay attention to the future balance of the new loan compared to the future balance of the current loan. This will prevent you from being suprised later to find out that you would have owed less had you kept the previous loan.
2. The second (and in my opinion – better) method of determining when it makes sense to refinance is when you compare all options side by side and keep as many things equal as possible while targetting on one area such as the future balance of each scenario. This option will allow you to see how much more profit that you will have if/when you either sell the home or how much interest overall you will pay throughout the time that you own the home.
For Example – See below – This borrower can see their current loan in “Scenario 1” and see how much they are paying now based on having 27 years left and what the balance will be if they keep the loan for 5 years.
“Scenario 2” shows them how a 30 year option will lower the payment by about $500 per month. But, if they continue making the same payment that they’re already used to making…in 5 years, they will have over $30,000 more in equity – doing nothing different that what they currently do.
Lastly, “Scenario 3” illustrates a 15yr mortgage term. Depending on the budget for monthly payment, this might be the best option. The payment is only a little more than their current loan payment, but the rate is much lower and the equity built is much by far the best option.
You can see that there are a number of variables to consider when trying to determine when refinancing makes the most sense. You’ll want to know if you plan on moving soon. If so, you’ll want to check the side by side balance in an earlier year such as year 2 or 3 if you think there is a possibility of moving or selling the home by then.
Also, depending on the balance of the mortgage in the refinance, you can see that some larger loan amounts break even much more quickly than smaller loan amounts – therefore a blanket rule of thumb may not apply.
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