The single most important thing to know about refinancing your house is this: How long is my payback period? The payback period is the time it takes you to recoup the closing costs you must pay in order to refinance. Recouping your closing costs occurs each month in an amount equal to the lower monthly payment that you have. However, it will generally take many years of these lower payments until the sum of all these payments finally is greater than the initial closing costs you paid. After that point, you are saving yourself money each month. But before that point, you are merely trying to save enough money to pay back your closing costs.
The reason it is vitally important to know your payback period is that if you are not going to own your house long enough to reach the payback period, it turns out that refinancing will actually be more expensive than keeping your interest rate the same. This is because you won’t have the necessary time to save the money needed to cover the original fixed costs.
So, how do you calculate the length of your payback period? You need to know the following variables:
1. What are your fixed/closing costs to refinance? In calculating this be sure to assume every cost that you wouldn’t have had to pay if you hadn’t refinanced. These costs include things like, appraisals, closing costs, loan fees, legal fees, and any other costs/fees you must pay in order to refinance.
2. What is your new interest rate?
3. What was your old interest rate?
4. What is the principal balance on your mortgage?
With these four pieces of information you can calculate your payback period as follows. First, determine the difference in your monthly payment by subtracting your new, lower interest rate from your old, higher interest rate. Second, multiply this difference times your mortgage principal. This will give you the annual interest savings (you will always have to pay back the principal amount so that doesn’t really factor into this analysis). Then divide the closing costs by the monthly interest savings to find the number of months it will take for you to recoup your upfront, fixed, closing costs. Finally, determine whether or not you will still own your house after that many months. If not, refinancing does not make sense. If you do think you will still live there, then refinancing may save you some money over the long-term.
Let’s look at an example to help crystalize this. Assume the following:
1. Total, upfront, fixed costs to refinance = $3,800.
2. Old interest rate = 6.75%
3. New interest rate = 6.375%
4. Principal mortgage balance = $130,000
In this example, the annual interest savings amounts to $487.50 a year, or $40.63 per month. Since the closing costs are $3,800, it will take over 93 months (or almost eight years) to reach your payback period.
Generally, the greater the interest savings, the lower the closing costs, and the higher the principal balance, the shorter your payback period will be.
As a final note, this analysis only works if you compare apples to apples. So, if you have a 30yr. mortgage and refinance to another 30yr. mortgage, then you can use the analysis above. However, if you have a 30yr. mortgage and you refinance to a 15yr. mortgage than the analysis above must be tweaked accordingly. We’ll save that analysis for another article. But the concept is the same – compare your savings to your fixed costs.