With home mortgage interest rates still hovering slightly below 3%, it is a very attractive time to take advantage of these all time lows. It is pretty easy to get lured into the slick marketing and promises of a lower payment but how do you know if a refinance really makes sense for you? The math is pretty simple but you will have to make a few assumptions regarding how long you plan to keep the property and what combination of rate/points is best for you. Here's a quick rundown of the math to help you decide:
I generally use a breakeven analysis to decide if a refinance is justified and how many points to pay. Basically, I am determining how much lower my payment will be and how many months of that savings it will take to cover the upfront fees and expenses. The easiest way to show this is through a hypothetical example.
Let's assume that my current mortgage is a standard 30 year fixed mortgage at 4.5% interest. The original loan was for $150,000 but the remaining balance is exactly $100,000. This makes the current Principal and Interest (P&I) payment $760.
Now let's assume that we can refinance the remaining $100,000 loan balance into a new standard 30 year fixed mortgage at 3.0% but it will cost us 1 point (1% of loan amount to reduce interest rate) and $1500 in fees for paperwork and an appraisal. The new payment would be $422.
Now here's the math to determine the breakeven:
Current payment $760
Less new payment -$422
Equals monthly savings $338
Now add up all of our loan costs:
1% point paid $1000
+ fees $1500
Equals loan cost $2500
For the final step, divide your loan cost by the monthly savings: $2500/$338 = 7.4
What this tells us is that in 7.4 months the savings of the new payment will cover the expenses of acquiring the new loan and we will be in the gravy after that. If you plan to keep the property for more than 8 months you should recognize a savings from refinancing. If you plan to sell before 8 months the loan expenses will exceed your savings and you will recognize a loss.
Another thing to consider is that a refinance resets the amortization table and extends the loan out another 30 years. This means that your payments for the first part of the loan will be primarily interest and you will be growing your equity in the property at a slower pace. To offset that you could refinance but continue with the $760 payment (or somewhere in between $422 and $760). Any additional payment over the $422 will go toward principal paydown and can significantly reduce the repayment term of the loan.
If you haven't already refinanced but are considering doing so, use this calculation to see if it is worthwhile for you.