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Here is what you will
learn in this tutorial:
1. What does "saving money" on a
refinance mean?
2. Should you finance the origination costs?
3. What hazards must be avoided?
4. Determining whether or not you will save money: what is the
"break-even" period?
5. How do you find the break-even period?
This tutorial is for those who want
to save money on their one existing mortgage. If you have a mortgage but
need to raise cash, or if you now have two mortgages, you must wait for
tutorials dealing with those topics.
What Does "Saving
Money" on a Refinance Mean?
Saving money means that over the
period you will hold the mortgage, the total costs net of offsets will
be lower on the new mortgage than on the existing one.
The costs include a) Origination
costs - points and other settlement costs, on the new mortgage only; b)
Monthly payments of principal and interest, on both mortgages; and c)
Lost interest on (a) and (b), also on both mortgages. Cost offsets on
both mortgages are tax savings, and reduction in the loan balance.
If the interest rate on the new
mortgage is lower and there are no points or other settlement costs, the
new mortgage will save you money, even if you pay it off after one
month. However, a "no-cost" mortgage carries a higher rate. If you
expect to have the new loan more than 3 or 4 years, you usually save
more if you pay your own settlement costs rather than have the lender
pay them in exchange for a higher rate.
Most borrowers, therefore, incur
refinance costs upfront that must be recovered over time through the
savings generated by the lower interest rate. The critical number is the
"break-even period" -- the minimum length of time you must hold
the new mortgage to make the refinancing pay.
Should You Finance the
Origination Costs?
Many borrowers who refinance today
finance the upfront costs. They add the costs to the mortgage rather
than pay them in cash. Usually, this reduces the gains from refinancing
because the borrower must pay interest on the upfront costs at the
mortgage rate. Pay the costs in cash if you can manage it.
What Hazards Must Be
Avoided?
The refinancing market is something
of a jungle, but you are safe if you observe one basic principle: You
cannot save money on a refinance unless the interest rate on the new
mortgage is below the rate on the existing one. Those who argue that
you will profit by refinancing into their mortgage at a higher rate are
either fooling themselves or are out to fool you.
Some con artists will show you that
your total interest payments will decline if you refinance into their
higher-rate loan. However, they get that result by assuming that you
will repay your new mortgage (but not your old one) on an accelerated
(biweekly) schedule. You don�t need to pay a higher rate to accelerate
your repayments.
Some others will show you that your
monthly payment will decline if you refinance into their higher-rate
loan. However, they get that result by extending the term. If your
current mortgage does not have many more years to run, an extension of
the term can reduce the payment by more than the higher rate increases
it. If you do it, you pay for it big time in the form of a higher loan
balance in future years.
Beware,
some mortgage calculators calculate a break-even period by dividing the
upfront costs by the reduction in mortgage payment. This is a phony
break-even because it ignores changes in the loan balance, tax savings
and lost interest.
Determining
Whether or Not You Will Save Money: What Is the "Break-Even" Period?
The break-even period is the number
of months before the savings from the lower rate completely offset the
upfront refinance costs. Even if you are not sure how long you will have
the mortgage, if you are confident that you will have it longer than the
break-even period, you know the refinance will pay.
To see a sample set of break-even
periods, click on Sample
Break-Even Periods.
Sample Break-Even Periods
How
Do You Find the Break-Even Period?
You find it in two steps. In step 1,
you collect the followng information:
Your Income Tax Rate:
This is the
tax rate you pay on your last dollar of income. If you pay only Federal
income taxes, it is the highest of the Federal tax brackets you used.
Currently, these brackets are 10%, 15%, 25%, 28%, 33%, and 35%. If you
also pay state and/or local income taxes, you should add the highest
bracket you used in connection with these taxes. For example, if your
highest Federal tax bracket is 28% and the highest state bracket is 5%,
you should enter 33%.
Remaining Term on Your Existing Loan:
This is the number of months until the balance is paid off if you
continue making the mortgage payments you are making now. It is the
original term less the number of months that have expired since
origination, provided a) you have a fixed-rate mortgage, and b) you have
not made any extra payments. If one or both of these conditions does not
hold, or if you do not know how many months remain on your existing
loan, use the Remaining Term calculator below to find your remaining
term.
Term on New Loan:
For borrowers looking for a fixed-rate mortgage (FRM), a 15-year term is
the best bet if you can afford the payment. Most borrowers who take
adjustable rate mortgages (ARMs) opt for 30-years, tho 40-year terms are
available.
Whether Points and Other Costs Are
Paid in Cash or Financed:
Finance the costs if you must, but doing so will extend the BEP. In some
cases, having to finance the costs could swing the refinance from
profitable to unprofitable.
Step 2 involves entering this
information into the
Refinance to Save Money Break-Even Tables calculator which will
generate your break-even tables.
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