When you decide to refinance a mortgage loan, the goal is to lower your monthly payment. The primary factor that influences your monthly payment is the interest rate on the loan. Savvy homeowners refinance when mortgage interest rates drop below the level they purchased at.
So if Sarah bought a home at a 5% interest rate a year ago, and today the rate is at 3.5%, she will save thousands of dollars over time by refinancing and taking advantage of the lower interest rates. Her monthly payment will be lower by several hundred dollars which will equate to thousands of dollars in savings every year.
That being said, when you refinance a mortgage loan you have to pay closing costs. This is where things get tricky. Closing costs can be anywhere between 2-6% of your loan amount.
So deciding whether or not to refinancing your loan should be based entirely on the answer to one question.
Can the amount of money I’ll save annually by taking advantage of a lower interest rate, repay the closing costs of refinancing within two years? That’s it.
For example, let’s say Sarah bought her home for $500,000 and put 20% down. That would mean the loan balance she is financing is 80% or $400,000. At a 5% interest rate, her mortgage payment is roughly $1666 every month. Stay with me.
A year goes by and Sarah has been making her payments every month. She’s paid down $20,000 on her loan over a year. Her new loan balance is $380,000 and she’s thinking about refinancing. Mortgage rates are at 3.5% and at that rate, her new mortgage payment would drop to $1108. She could reduce her payment by $558 a month saving herself $6700 every year.
But what will Sarah’s closing cost be when she refinances? Well her loan balance is $380,000 and the closing cost estimate is 3% of that balance. She will pay $11,400 in closing costs.
Deciding whether or not to refinance her loan will be based entirely on the answer to the one question.
Can the money she’ll save annually cover the closing costs of refinancing within two years?
In Sarah’s case, her savings will be $6,700 a year. In two years she is saving $13,400. Her closing costs are $11,400. She’s making a great decision refinancing.
Now some of you may be asking why I used two years as the benchmark. Here’s why. If you plan on selling your property in a few years, refinancing won’t be worthwhile once you factor in all the closing costs. The faster you can recoup the closing costs the better.
So if you plan on keeping your home for 5-10 years, and your annual savings can repay the closing costs in two years, you’re winning the refinance game.