A mortgage refinance just means you get a new mortgage loan that takes the place of your existing loan by paying it off. Mortgage refinancing becomes very popular when interest rates become relatively low, allowing a chance for homeowners to get in a better financial position. A common tool used to gauge whether a refinance is a reasonable investment move is a break-even analysis.
People refinance mortgages for a variety of reasons, one of which is reduction of the interest rate if the original loan was obtained at a time when rates were higher. Homeowners also are looking to reduce the amount of interest they pay over the repayment period, which helps build equity faster, or lower monthly payments by extending the loan term.
A number of factors must be considered when deciding whether a refinance is the right move. However, a great starting point is a simple break-even tool. When you get your new mortgage, you pay closing costs, just as you did when you got your first loan. Your break-even point is the date on which you would save enough from the reduction in your new monthly payments to cover your closing costs. In general, if you plan to live in the home beyond the break-even point, your refinance makes sense.
Assume a current mortgage payment of $1,000 and a principal loan balance remaining of $150,000, with about 20 years left on the repayment period. If you refinance to a new 20-year loan with a rate cut from 4 percent to 3 percent, your payment would fall by roughly $100 a month. With closing costs of $3,000, you would need approximately 30 months of savings on your payments to recoup your finance fees.
The break-even formula is a very rudimentary starting point in analyzing a refinance since you are often comparing apples to oranges. For example, if you were to stretch your loan back to a 30-year term, your monthly payments would go down much more, but some of the reduction would be from the increase in installments as opposed to interest reduction. Additionally, going from a variable rate to fixed rate, or vice versa, makes for a challenging comparison. The break-even calculation is a way to decide whether to further investigate options.
Neil Kokemuller has been an active business, finance and education writer and content media website developer since 2007. He has been a college marketing professor since 2004. Kokemuller has additional professional experience in marketing, retail and small business. He holds a Master of Business Administration from Iowa State University.