There’s no one way to calculate the true savings from refinancing a mortgage. You can - and should - crunch the numbers to make sure that the refinance will actually save you money (it doesn’t always). But you also have to take non-monetary factors into consideration.
Let’s take a look at several methods to calculate savings from a refinance as well as some of the non-monetary factors that are involved.
The Two Points Rule
This is the simplest way to calculate if your refinance will actually save you money. But it's a very dated rule, so we're not going to spend a lot of time on it.
Back when mortgage rates were substantially higher than they’ve been since 2008, it was generally held that it was worth doing a refinance if you would be lowering your interest rate by at least two percentage points. So if the current mortgage was 10% and you could refinance the loan at 7.5%, it was worth it.
Of course, that was back in the days when you could lower your rate by that much. If you have a mortgage that’s 4. something, it’s largely a moot point, unless rates drop well below 3%. However, if you currently have a mortgage rate of greater than 6%, then the rule still holds.
It's a simple rule, except that it doesn't apply in most cases anymore. And even if it does, you'll still need to apply the next method as well.
Closing Cost Recapture Period Method
Like the two points rule, this method is also a convention, but one with more specific calculations. It is also more relevant to far more people's mortgage situations.
The basic idea is that you measure how long it will take to recapture the closing costs on the new mortgage through reductions in your monthly payments. The rule holds that you should be able to recapture your closing costs within 24 to 36 months of taking the new loan.
Let's look at a couple of examples to demonstrate how it works:
Example #1: You have a 6.50%, 30-year mortgage with a remaining balance of $200,000. You have an opportunity to refinance the mortgage at 4.50%, with $5,000 in closing costs. The analysis looks like this:
- Current mortgage: 6.50%, monthly payment, $1,264
- New mortgage: 4.50%, monthly payment, $1,013
- Monthly savings: $251
- Closing costs: $5,000
The closing cost recapture period is calculated by dividing $5,000 in closing costs by the monthly savings of $251, which looks like this: $5,000/$251 = 19.92 months, or 20 months rounded up.
Since the closing cost recapture will occur in significantly less time than 24 to 36 months, the refinance is generally worth doing.
Example #2: You have a 5.50%, 30-year mortgage with a remaining balance of $200,000. You have an opportunity to refinance the mortgage at 4.50%, with $6,000 in closing costs. The analysis looks like this:
- Current mortgage: 5.50%, monthly payment, $1,136
- New mortgage: 4.50%, monthly payment, $1,013
- Monthly savings: $123
- Closing costs: $6,000
Calculating the closing cost recapture period by dividing $6,000 in closing costs by the monthly savings of $123 we get something that looks like this: $6,000/$123 = 48.78 months, or 49 months rounded.
Since it will take you more than 36 months to recapture your closing costs, the refinance is probably not worth doing.
Now, it could be argued that if you plan to stay in the home for substantially more than 49 months, the refinance will still be worth doing. The problem, however, is that there’s no way to know for sure what you’ll be doing 4+ years from now. Should a job transfer come up that requires you to sell your home in less than 49 months, you would lose the non-recaptured closing costs forever.
Paying discount points with a refinance. The closing cost recapture period also makes a strong argument against paying discount points to permanently lower your interest rate in conjunction with a refinance. The cost of the points, each representing one percent of the new loan amount, will make your closing costs even higher. This considerably extends the closing cost recapture period. The approximately 0.125% reduction in your interest rate gained by buying a discount point will hardly be worth the cost.
When deciding whether or not to refinance, there are times when crunching numbers doesn’t really matter. Generally speaking, this happens when you are planning to do a refinance that will eliminate a high-risk loan.
- A subprime mortgage - The terms on these loans are so dangerous that the only motivation should be to get out of it. They usually involve some sort of six-month adjustable-rate term with the potential of the rate going to double digits. And for that reason, the math will almost always work in your favor.
- ARM loans - A lot of homeowners have benefited from having adjustable-rate loans. But, that’s only because interest rates have behaved exceptionally well in recent years, mostly going down. But should that trend reverse, an ARM will quickly turn into a negative arrangement, possibly involving increases in both the rate and monthly payment. If you have an opportunity to replace a variable-rate mortgage with a fixed-rate mortgage, it’s almost always worth it - especially with fixed-rate loans staying as low as they are.
- Refinancing a first and second combination - More specifically, if you have a large-balance home equity line of credit (HELOC) with a variable rate, it may be worth refinancing a new first mortgage that includes your existing first and the HELOC. This is because HELOCs function like credit cards secured by your home, and the interest rate structure they carry usually isn’t much better than credit cards. If the HELOC represents a large percentage of the current debt on your home, doing a refinance that will roll the HELOC into the new mortgage is usually a solid decision even if the math doesn’t look terribly encouraging upfront. Once again, it’s a matter of eliminating high-risk debt even if the math doesn’t seem to support it.
Three Major Mortgage Deceptions to Avoid
Should you decide to refinance, there are a few conditions that you need to be aware of. They're deceptions that make you believe that a refinance is better than it actually is. Here are three of the most significant.
Extending the loan term. This is a common practice with refinancing. You're five years into a 30-year loan - which means you have 25 years remaining and you refinance into a new 30-year mortgage. No matter how much you're saving on the monthly payment, you're adding a very large additional outlay on the back end of the loan.
If you are refinancing a $200,000 loan with 25 years remaining on it into a new 30-year mortgage at 4.5% - or $1,013 per month - you’re adding five years of payments, or 60 months to the back end of the loan. That means that you will pay an extra $60,780 on your mortgage over its lifetime ($1,013 X 60 months). That’s almost certainly more money than you will save on your monthly payments over the life of the loan.
In order to know if a refinance is really worth doing, you must make sure that the term of the new mortgage doesn’t exceed the remaining term of your current loan. That means that if you’re three years into a 30-year mortgage, the new mortgage should be no more than 27 years.
Increasing the loan balance. Homeowners sometimes do what can be referred to as a "soft cash out" on a refinance. That's where they roll both closing costs in prepaid expenses (escrows for property taxes and insurance) into the new loan. That can add thousands of dollars to the loan balance, and it is done to prevent the homeowner from having to pay those costs out-of-pocket. But cash comes back to the borrower when the escrows established on the original mortgage are returned. It could represent thousands of dollars.
If you’re adding both the closing costs and prepaid expenses to the new mortgage, you’re increasing the loan balance by thousands of dollars. Under extreme circumstances, you have to consider whether replacing a $200,000 existing mortgage with a new loan at $210,000 is really your best interest. It’s a strategy that you will want to avoid if you’re planning on selling your home in the near future or if property values in your area are either flat or declining.
Refinancing for debt consolidation. On the surface, consolidating thousands of dollars in high-cost revolving debt into a low fixed-rate mortgage makes a lot of sense. But this is another example of where math may not necessarily matter.
I spent years in the mortgage business and saw a familiar pattern: People who did debt consolidation refinances on their homes, were usually back in debt within two or three years. The pattern was too common to ignore, and I heard the same report from other people in the industry.
There’s something of a moral hazard that comes from doing debt consolidations, particularly large ones on the home. Once you consolidate your non-housing debt successfully, even one time, you assume that you can do it again. The motivation to actually reduce debt by paying it down or paying it off fades. It sets up a pattern of people doing serial refinances primarily for debt consolidation, done every 2 to 3 years. This is especially prevalent in rising real estate markets.
There are several problems with this strategy. You might recognize them from the mortgage meltdown:
- Consolidating debt doesn’t lower the borrower’s debt levels. It just changes the type of debt that is owed.
- Adding non-housing debt to the family homestead puts the home at risk.
- Should property values decline, the homeowner can be trapped in the home, unable to sell or refinance.
Please consider these factors if you are refinancing your mortgage primarily to consolidate non-housing debt.
You’re probably sensing that the decision to refinance your mortgage isn’t quite as simple as it seems. And in truth, if you consider all that’s involved, it really isn’t. That’s probably as it should be. After all, a mortgage is secured by one of your most important assets, your home. Caution should always be the order of the day.