Mortgage rates today are hovering near historic lows. Rates now may be significantly lower than they were when you purchased your home.
Should you refinance? Before you can answer that question, you’ll need to determine the break-even point -- the point at which the costs associated with refinancing turn into an overall net savings.
Read on to see a few questions that you should ask yourself before you pay thousands of dollars in closing costs on a home mortgage refinance.
A quick note before we begin -- rate and term refinancing (often just called refinancing) is the most common, so that’s what we’ll focus on here. This is when you close out your old mortgage and open a new one with a lower interest rate or different terms, such as switching from an adjustable-rate to a fixed-rate loan or vice versa.
It’s a pretty decent deal, but you will have to pay closing costs again. So how do you know if a rate and term refinance is worth it? You’ll need to weigh three factors: home mortgage rates, closing costs, and the length of time you’ll hold onto your home.
How do you calculate the break-even point?
Use this simple formula to estimate your break-even point: Take your total closing costs and divide them by the potential monthly savings. The result is the number of months it will take you to break even.
Let’s say that in 2010, you took out a loan for $200,000 at a five percent interest rate. Today, you have $180,000 left on your mortgage, and you’re thinking about refinancing at a four percent interest rate.
When you run these numbers through a mortgage calculator, you’ll see that refinancing will save you $214 per month under these circumstances.
Next, let’s assume that closing costs on the new loan would equal $3,600, or two percent of the loan balance.
That amount, divided by $214, equals 16.82, which means it will take you 17 months to break even on this refinance. If you plan on holding onto your property for significantly longer than that, refinancing might be a good idea. If not, the efforts might not be worth it.
If the refinance rates that you’re considering pass the break-even test, that’s good news. You just need to ask yourself a few more questions:
- If the refinance lengthens the mortgage (by starting a new 30-year fixed term), are you okay with sticking out the duration? Or, would you be willing and able to prepay to shorten this?
- Do you have the time and energy to manage the refinancing process? Keep in mind that lenders will need to see a significant amount of paperwork, a title search and an appraisal, so this process may take a few months.
If you answered yes to these questions, you may want to take the leap. Crunch the numbers in a refinance calculator, like this one on State Farm’s learning center, to see if this step could help you lower your interest rate or accelerate your debt payoff.