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Financial Learning Center


Refinancing Your Mortgage

When Does It Make Financial Sense to Refinance?

To determine if you should refinance you'll need to do two things:

  • gather information from potential lenders regarding interest rates, fees, and loan types
  • evaluate the information to determine if the refinance makes financial sense for you

By the term financial sense, we mean "Will it wind up saving you money in the long run?" There may be costs associated with refinancing a mortgage. A refinance only makes sense when you will stay in your home long enough to recover the costs of refinancing. This period is called the "break-even point." So, if you'll only be in your home for a few years, it may not make sense to refinance. Take a look at the break-even point example below. You'll also need to evaluate whether or not it makes sense to pay points. See the section "Understanding 'Points'" below.

The Costs of Refinancing

See the "Costs of Refinancing" worksheet. On it you'll find a list of the typical fees associated with refinancing, including points, the application fee, title search and insurance, inspections, a survey, an appraisal, and attorney and recording fees.

The worksheet gives examples of these fees; these examples add up to $3,000—but this is only an example. To be thorough about it, you should fill out the worksheet with actual amounts from lenders that you talk with.

The Break-Even Point

Once you have an idea of the costs associated with refinancing, you need to determine if it will wind up saving you money in the long run. If current rates aren't that much lower than your existing rate, but you plan to stay in your house for a long time, you may still save money by refinancing.

Examine the calculation below, which computes the amount of time it will take to recover the cost of refinancing, i.e., the break-even point.

IMPORTANT NOTE: If your break-even point exceeds the length of time you intend to stay in your home, don't refinance. For example, if it will take 29 months to recover your refinancing costs and you plan to be in your home for 22 months, it will not pay to refinance.

Break-Even Point Example

1. Current monthly mortgage payment

=

$878

2. Minus: New mortgage payment

$734

3. Equals: Pre-tax savings per month

=

$144

4. Multiply by: Your tax rate (e.g., 25%)

x

25%

5. Equals: Tax effect

=

$36

6. Pre-tax savings per month (line 3)

=

$144

7. Subtract: Tax effect (line 5)

$36

8. Equals: After-tax savings per month

=

$108

9. Total cost of refinancing

=

$3,000

10. Divided by: After-tax savings per month

÷

$108

11. Equals: Number of months to break even

=

28 months

What does this mean? If the homeowners in the example plan on staying in their home for 29 months or more, they will save money by refinancing. They will have gotten back the $3,000 it cost for the refinance in the 28th month. However, this analysis doesn't take into consideration the time value of money. If the time value of money is factored in, the break-even point will be slightly longer.

Understanding "Points"

Let's begin by looking at something you always hear about when you talk mortgage basics: points.

Lenders make money on mortgage loans in two ways: By charging you interest, which you pay each month when you send in your payment, and by charging you a "loan fee," commonly called "points," which are paid when you take out the mortgage loan.

Some loans are "no point" loans, which means that no money is collected up front for buying a particular interest rate. Of course the typical fees (credit report, appraisal, flood, etc.) still apply. While this helps you with the cash that you need when buying the home, the tradeoff is that the amount of interest you pay each month will be higher. There are also some unique tax treatments in conjunction with points paid on a refinance as opposed to points paid on obtaining an original loan; see the section What Can You Deduct on Your Tax Return?. Sounds simple enough, but what does it mean to you? How do you choose between two different loans and decide which loan is cheaper for you?

One easy measure is to compare each loan's annual percentage rate (APR). Each lender is required by law to provide you with this information. When trying to decide between two loans, generally the one with the lower APR will be the cheapest.

The problem is that the APR is computed as if you held the mortgage until you completely paid it off. What if you only intend to stay in this home or keep the mortgage for five or six years?

You'll need to look at the effective annual interest rate (see below).
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