When is the correct time to Refinance my Mortgage?
Our clients often ask us if there is a “rule of thumb for refinancing my mortgage?”
A mortgage has two primary components: the Interest Rate (cost of money) and the Terms (amortization, aka length of repayment).
Related to the decision to refinance are the Loan Costs (previously referred to as Closing Costs)
Most of our clients forget you can adopt to any shorter amortization, at any time, without permission or expending costs or time. For instance, the 30-year mortgage you just closed on, could be converted (accelerated) to a 24 ½ year mortgage to match your financial priorities. Re-Amortizing is free and easy.
Several times each month we talk potential clients OUT of refinancing to a 15-year mortgage by explaining they can do that for FREE and save the time investment it takes to refinance. The re-amortization will not unlock a lower rate, however – but then again a lower rate isn’t always available.
The Rule of Thumb for refinancing depends on:
- The size of your mortgage (“Loan Balance”)
- The difference between your current rate and the proposed rate (“Delta”)
- The actual Loan Costs (not including escrow or “Other Costs”)
The Delta multiplied by your Loan Balance = your raw 1st-year interest savings. I like to divide the raw savings into the Loan Costs to spit out an approximate number of years it takes to “Break Even”.
Please keep in mind that to “Break Even” is not your goal. You need to make a Return, or Profit. The Profit occurs at the monthly savings rate AFTER you have met your Break-Even point.
Sometimes a mortgage is at a Point-of-no-Return and even if the rate Delta is a 5% improvement there isn’t enough time left to recoup the loan costs. We’ve seen this more often than you’d expect.
An easy apples-to-apples comparison is to calculate your new proposed payment using an amortization that matches (to the month) how many months you have remaining on your current mortgage. That payment differential represents your monthly savings. Your monthly savings multiplied by the months remaining represents your TOTAL SAVINGS.
If you extend your 28-year-remaining mortgage back to 30 years, the payment Delta represents (A) savings due to Lowering Your Interest Rate and (B) cash flow betterment due to stretching your mortgage our by an additional 24 months … We can’t really call that “savings” can we? I call it “The Stretch”.
Some of your refinance options include an actual 28 year mortgage, or the self-discipline to apply the 28 year mortgage payment to your new mortgage. This can usually be set up to be done automatically.
We like the latter choice. This gives you a future option of “relaxing” the payment back to the 30 year payment without needing to refinance back to a 30 year mortgage if you run into a cash flow crunch. Please remember refinancing has costs and takes your time. There is also an uncertainty about where rates will be in the future should you ever encounter a financial emergency.
So the Rule-of-Thumb-for-Refinancing-My-Mortgage looks like this:
Assuming Loan Costs of $3K and a (true) monthly savings of $50 (no Stretch of your term) you would have a 60 month break-even-timeline. Not including the time-value-of-money, the investment won’t return a worthwhile profit until around the decade mark.
While these numbers may excite some people, anyone who sells their home OR refinances before the decade mark has shortchanged themselves.
Yet a savings of $250 a month brings the break-even-timeline down to 1 year and an additional year for earning profit.
We routinely utilize No Loan Cost Applications, formerly know as No Closing Costs. This type of application comes with a mild interest rate premium, decreases the interest rate Delta, but it also eliminates the Break-Even-Timeline.
We are happy to talk it through with you without even a hint of an obligation to engage our services.