Rates are the singular factor to determine whether refinancing is a good idea; closing costs amortized make make the mortgage more expensive in the long run. Find a rate that reduces monthly payments and gets you to a breakeven point sooner. Each homeowner must base the decision to refinance on individual circumstances, but some guidelines will let you know if it is time to look at the options.
Tradition Idea of Refinancing
The traditional rule of thumb is that it makes financial sense to refinance if the new rate is 2 percent or more below your existing interest rate. The new rate on a refinance must provide enough savings in monthly mortgage payment to justify the cost of refinancing. The secretary's webpage also notes that circumstances are different for every homeowner.
Considerations of Costs
The refinance decision should compare the three factors of monthly payment savings, the cost to refinance and how long the homeowner plans to stay in the home.With closing costs being anywhere from 2 to 5 percent, a $600,000 might have closing costs of $18,000 to $30,000. If the payment savings from a lower rate refinance is approximately $130 per month, and closing costs were approximately $12,000, it would take approximately 7 years to break even.
A larger mortgage size can show benefits from refinancing with a smaller decrease in the interest rate. A 1 percent rate savings lowers the payment $60 t0 $65 per $100,000 mortgage balance per month. On a $400,000 loan the payment savings will be about $250 per month. The refinance costs of the larger loan will be higher, but not proportionately higher. The homeowner with a lower current mortgage balance may need the 2 percent rate savings to have a refinance make sense. Homeowners with larger mortgage balances could achieve sufficient cost savings with a 1.5 or 1 percent rate drop.
Change of Strategy
The rate savings may not be as large a factor if the homeowner is changing strategies to pay off the home. The best example is going from a 30-year mortgage to a 15-year loan. The homeowner will want to have the new loan at a lower rate, but there will not be any payment savings. The savings will come from having the mortgage balance pay down faster and getting the home paid off years earlier than with the existing 30-year mortgage.
A homeowner should consider how long she plans to keep the home when considering a refinance. If the plan is to own the home for a long time, the interest savings from a modest rate decrease can be significant. On a $200,000 loan, decreasing the rate from 6 percent to 5 percent, decreases the total interest paid by almost $50,000. The homeowner who plans to keep the home for only a few more years can consider a hybrid ARM like a 5/1 ARM, where the initial rate is fixed for the first 5 years. For example, consider a rate of 3 percent on a 5/1 ARM compared to 4.375 percent on a 30-year fixed mortgage. The extra 1.375 percent in rate savings equates to $14,000 in payment savings over 5 years.
About the Author
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.
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