Find out if doing a refinance is best for your situation.
Refinancing is when you apply for a new loan in order to pay off an existing loan balance. The new loan could be with your same institution or with a different lender. You basically swap out a higher-interest loan for a lower-interest one, which decreases the amount of interest you have to pay. That sounds easy enough, but of course, there’s a cost to doing a refinance. It seems like it takes a village to close a loan and everyone gets their cut. Fees go to the lender or mortgage broker, the property appraiser, the closing agent or attorney, the surveyor, the local government, and maybe more people, depending on where you live.
Each lender has different requirements for doing a refinance. Most will require that you have a certain percentage of equity in your property. Equity is the difference between what your home is worth and what you owe on it. For example, if your home is valued at $200,000 and you have a $150,000 mortgage, you have $50,000 in equity, which is 25% of the value.
Should You Refinance Your Mortgage?
Just because you qualify for a refinance doesn’t necessarily mean that it’s right for you. Refinancing a loan can be expensive. The total cost will depend on the lender as well as the location of the property and could be as high as 3% to 5% of the outstanding loan balance. The trick is to understand what a refinance will cost and how long it’ll take to break even on those costs. In other words, when do you move from being in the red to being in the black on the deal? If you pay for a refinance, but don’t keep the home long enough to cover the costs, you’ll lose money. But if you do keep the property beyond the financial break-even point (BEP), you’ll feel like a genius because you’ll save money in the long run!
You may be able to roll closing costs for a refinance into the new loan, which means you would have nothing or little to pay out-of-pocket. But doing that increases the amount you have to borrow and may also increase the interest rate you have to pay for the life of the loan. For that reason, it’s important to ask the lender for a side-by-side comparison of all the terms for each loan option so you can carefully evaluate them.
How to Figure a Refinance Break-Even Point
So how do you figure the financial break-even point? It can be a little complicated, but don’t worry, I’ll give you a great online tool that’ll make it a breeze. The break-even point depends on various factors, including:
the interest rates on the old and new loan,
total closing costs,
your income tax rate,
how long you plan to own the property, and
any loan prepayment penalties you may have to pay.
Ben, my recommendation is to use the refinance break-even calculator at dinkytown.com to help determine if refinancing makes sense for your situation.
That calculator can help you cut through the confusion of making an important financial decision such as doing a refinance, but remember that it’s not perfect. For instance, it doesn’t know if you’ll take advantage of the home mortgage interest deduction, which would decrease your taxes and after-tax interest rate you really pay for a mortgage. For more information about how the home mortgage interest deduction works, be sure to refer back to post number 141. But using a refinance calculator will show you how long you’d need to keep the property to recapture all your upfront closing costs, which is usually what most people want to know.
What are Other Reasons to Refinance?
The goal of doing a refinance is generally to save money on monthly loan payments by getting a lower interest rate. However, there are other reasons to refinance. For instance, you might want to convert an adjustable-rate loan into a fixed-rate loan. That would lock in a low rate if you believe interest rates are going to rise. Or you might want to cash out equity that you’ve built up in a property to pay for something like a remodeling project or the cost of education for you or a child. Whatever your reason for doing a refinance, be sure to carefully weigh all the costs against the savings you expect to receive.
If you have an underwater mortgage (your home value is below the normal loan to value underwriting guidelines) and would like to refinance, check out my Quick Tip on how to go about it.
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