Is It Time to Refinance? Better Run the Numbers
I've been getting lots of calls recently from clients about refinancing their mortgages. With rates so low, you'd think the decision should be a no-brainer. Not so. You really have to run the numbers to see if refinancing will save you any money. If you aren't careful, it may cost you more.
Why is it so confusing? Appraisals, points and closing costs, basically.
- Appraisals. To qualify for the best rates, you generally need to have 20 percent equity in your home. With the decline in real estate values, lenders are often hammering homeowners on appraisals. If you can't qualify for 20 percent equity, you may need to buy purchase private mortgage insurance, or PMI, to get the best rate. PMI is expensive and can quickly wipe out the advantages of the lower interest rate.
- Points. Lenders often charge points on their loans. One point equals one percent of the loan value. So the bank might advertise a low rate, but you have to pay one point to get it. The points add to your total cost of the loan, and add to the bank's profits.
- Closing Costs. These costs cover everything from the document fees to FedEx charges. They can range from competitive to ridiculous. Some lenders shove lots of extra costs into these categories to increase the profitability of the loan.
Let's say you want to refinance a $250,000 loan. Points and closing costs add up to $6,000, but the new loan offers a lower interest rate of five percent, down from from 6.25 percent. That would drop the monthly payment on a 30 year mortgage from $1,539 to $1,342, for savings of $197 a month. In other words, it would take about two and a half years to make up the closing costs of the loan.
But that's not the end of the analysis for most people. Suppose you were already five years into your original 30 year mortgage. Refinancing to a new 30 year loan means you'd add on five more years of payments.
To make a better comparison, you have to calculate how much it would cost to pay off the new loan in 25 years at the lower rate. In this example, it costs about $1,461 a month, or a savings of $78 a month compared to your old loan. Now it is going to take you more than six years to recoup the costs of the loan. It may still be a good deal, but you need to be sure you will be in the home long enough to benefit.
And if you got a lousy appraisal, you might also have to buy PMI, which could drive the cost of the new loan above the cost of your old loan.
Bottom line: Don't barrel into refinancing until you work through all of the numbers. A rate that looks good at first may cost a lot more than you think.
Fannie Mae has a good guide on refinancing issues that I think you will find helpful.
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