Refinance or Not?

Not everyone can save money with refinancing even at the time when interest rates are plunging low. How do you decide whether or not refinancing make sense for you?

Your situation matters

The rule of thumb is often said that:

If the interest rate on your current mortgage is at least two percentage points higher than the prevailing market rate, you're a good candidate for refinancing.
It takes at least three years to realize fully the savings from a lower interest rate, given the costs of the refinancing.

When it comes to mortgage refinancing, however, such rules of thumb can be misleading. It's hard to come up with one rule that covers all the possible scenarios with reasonable accuracy. Whether or not refinancing will save you money and how much you will save will vary dramatically depending on your situation.

Interest rate cut– The lower the interest rate cuts you can get, the more savings you will have with refinancing.
How long you plan to hold the new mortgage – While you are making monthly payments, the up-front costs will be recouped and then exceeded by the benefits in time. If you’re going to be in the house long enough to reach that breakeven point, you might want to proceed.
The loan amount – The larger the loan, the greater the benefits. For those with large loans, it is easier to recoup the costs with a smaller drop in interest rates because some of the closing costs are fixed.
How many years you've already paid on the current mortgage – The heaviest interest charges are at the start of the loan. It won’t make sense to start paying the interest all over again if you are already far into paying down the loan because most of what you’ve got left to pay is the principal anyway.
The opportunities for cutting closing costs – Less cost means bigger savings. However, cutting your closing costs might increase the interest rate of your new loan.

What to Consider

As the benefits of mortgage refinancing varies dramatically depending on your situation, the only way to determine whether refinancing is for you is to go about it the right way: by analyzing the monthly savings and the total interest savings.

1. Monthly Savings

Will your savings from reduced mortgage payments be greater than the up-front costs?” You can answer this question by analyzing the benefits, the costs, and the time to recover the costs.

Benefit: How much would you save on monthly payments?
Figure your monthly savings by subtracting your refinanced mortgage's monthly payment from your current monthly payment . Consumers save about $30 for each half-percentage-point drop in interest rates on a $100,000 loan.
Costs: What are the up-front costs?
Add up all the costs. Up-front costs on a mortgage loan generally range from 1% to 2% of the loan amount. The Real Estate Settlement Procedures Act requires lenders to provide a good-faith estimate of these fees to consumers within three days of applying for a loan.
Time to recover the costs: Divide the up-front costs of the loan by your monthly savings. The result is how many months it will take to recoup the refinancing costs through the monthly savings.
How long you'll stay in your house: Assess your time frame realistically, considering all possibilities, such as whether your job could change or if you could be transferred. If you’re going to be in the house long enough to reach that break-even point, you may want to proceed.

2. Total Savings

If you just compare the monthly payments, you might be missing a very important point. While refinancing reduces your monthly payment, it also stretches out the term of your loan -- which can dramatically increase your total cost. Once you picked the prospective loan product, calculate the total life-of-loan interest savings you can make by refinancing.

Compare the interest of your current mortgage and the new mortgage on the same principle: For example, if you plan to hold your loan for five years, total the interest for the first 60 payments on the prospective loan and compare the results with your current loan. If this total interest savings exceed the up-front costs, refinancing may work for you.

You can use the online amortization calculator to make the comparison easier. An amortization calculator breaks down each monthly payment into interest and principal amounts for any interest rate.

If you decide that refinancing is not worth the costs, ask your lender whether you may be able to obtain all or some of the new terms you want by agreeing to a modification of your existing loan instead of refinancing.