In talking about refinancing, I recently mentioned the concept of the mortgage refinance “payback period, ” which is the length of time that it will take to recoup the costs associated with refinancing. While there are a number of mortgage refinance calculators available online, I thought I’d give you a quick and dirty explanation of how to calculate your payback period.
Calculating your payback period
For starters, you’ll need to know how much it will cost you to refinance. You can get an idea of these costs by getting a good faith estimate from your prospective lender. Keep in mind that, for the purposes of this exercise, you should ignore escrow items such as taxes and insurance. The reason for this is that these amounts are essentially prepayments for items things that you will have to pay for whether or not you refinance. Moreover, you likely already have escrow funds encumbered with your current lender, and you will be receiving a refund following your refinance. As an aside, one way of reducing your closing costs is to request a reissue rate on your title insurance.
Once you know how much your refinance will cost you, you need to figure up your cost savings. To do this, compare your new monthly payment to your old monthly payment. To be sure that you’re comparing apples to apples, simply tabulate your principal, interest, and any applicable mortgage insurance under the two scenarios. Once again, you can safely ignore homeowner’s insurance and property taxes as you’ll have to pay those amounts under either scenario.
Once you have these numbers in hand, simply plug them into the following equation:
Payback Period (in months) = Closing Costs / Monthly Savings
As I’ve noted previously, the length of the payback period is an important factor in deciding whether or not to refinance your mortgage. If you can’t recover your closing costs in relatively short order, you might want to think twice about pulling the trigger. This is especially true if you’re not sure that you’ll be staying in your house for the long term.
Consider the total cost
Another wrinkle to consider is how much you’ve already paid on your current mortgage. If you’ve been in your home for awhile, then you’ve already sunk a good bit of money into original mortgage. In that case, you should also take a look at the total cost to own your home with and without the refinance. In other words, figure out how much you’d pay over the life of your original loan (without the refinance) and compare that amount to how much you would pay over the life of the new mortgage plus what you’ve already paid toward your original mortgage.
The bottom line here is that you need to be careful not to fall into the trap of lowering your monthly payment while increasing your total cost to own your home. I wrote a bit about this angle in an earlier article where we were considering whether or not to refinance our mortgage. In our case, we weren’t very far into our original mortgage, so it wasn’t a huge consideration. We ultimately pulled the trigger, though we also dropped from a 30-year to a 15-year term when we did it.
@ JT – if your goal is to pay off the mortgage faster then it is worth it. Good job ! Some will say invest it, some will say look at the increase in property value vs. investment opportunities, etc. In the end, it is your choice based on your lifelong plans. 44/month is not a whole lot if you consider knocking off 12 years from a debt contract.
@ Matt; I am not paid any more if I increase the interest rate (why should I)than what they offer. This is a bad practice and it will close the mortgage brokerage practive all in all if this happens as we are competing with big banks on rates. I actually avail of the rate reduction request that we are privelaged with for some lenders. I check the rates at a certain period prior to closing and then discuss a rate reduction with the lender = 9 out of 10, I get a reduced rate. I make my clients very happy as I consider their mortgages like my own. I could be naive and don’t do as what you mentioned but this is my value proposition – if you want debt free – Call me !
went from 27 years remaining bi weekly at 6.875 to biweekly at 4.0 for 15years cost is 44.00 more monthly was it worth it?
Gene, The longer the finance term the more of a payment will go towards interest.
yes it changes unless you happen to be exactly on your anniversary payment for the exact term you are refinancing for. If you had a 30 year originally and after your 120th payment you refinance for a new 20 year there would be no difference in the equity/interest split. And since you mentioned it I feel the change in Equity per month should be included in the payback calculation. It should be netted out with the change in payment to calculate the payback period.
During the length of a refinance loan does the monthly dollar amount of interest paid increase or decrease?
Kris and I still haven’t refinanced. We talked about it at the end of December, but we never pulled the trigger. Your post makes me want to get off my ass, get on the phone, and call around. I am, however, getting lots of e-mail from Lending Tree, which I had pinged back when I began to research a couple of weeks ago. Annoying.
Regarding Thomas’ comment:
The broker is using the same tools available to anyone. If you have the same information as the broker, you can, and should, run the numbers yourself.
I also have to disagree about getting the “real deal” when you ask the “experts” (brokers). Brokers are a necessary evil in the mortgage industry, but don’t always assume they are giving it to you straight. They are only paid when the deal is closed. Furthermore,they are paid extra when you get a bad deal (the higher the interest rate they sell you, the higher thier commision, likewise with higher closing costs), so what is the motivation for them to give the best deal available? Other than risk losing you to another broker, not a whole lot.
This is a timely post in light of news today that mortgage rates hit a new benchmark low.
calculators can only do so much. I’ve looked at refinancing using banrate and other sites but the numbers ended up being very different when it came to the real deal working with a broker. Online you can get some ideas, but only when you ask the experts will you get the real deal.
We’re attempting to refinance right now, from 6.75% to 4.75%, one year into the mortgage.
Our thoughts: A lower monthly bill is almost like an annual salary raise. The extra money may be there, but we’re quite comfortable living with our previous salary/mortage payment. We plan to continue paying the same amount, regardless of the interest rate and minimum payment. This should shave 10 years off of our mortgage, and give us a small monthly buffer if we come upon hard times.
Yes, yes, the tax deduction. For the size of our mortgage, itemizing won’t be worth it under the new rate, and would have only worked for the first 7 years under our old rate. Three cheers for lower interest rates and country living!
Thanks for the post, timely topic!
Yes, you are both correct. I’ve written a bit about this wrinkle in the past when we were deciding whether or not to refinance. Here is the link:
http://www.fivecentnickel.com/how-to-decide-when-to-refinance-your-mortgage/
I’ll update the article to point this out. Thanks.
Yeah, I was thinking the same thing as Matt here. I think that will give a pretty close result though unless you are changing the number of years by a lot. Also, I think it matters if the closing costs are prepaid or rolled into the new loan.
You failed to mention one important element of determining where you stand. Most people refinance into a standard loan length, like 30 years. But if your current mortgage has 25 years left on it, and you refinance to a 30 year mortgage, part of your lowered payment is due to extending the mortgage, which isn’t actually saving you any money. If a lower payment is your ONLY goal…..then why not extend the mortgage to 40 years? But if you want to see how much money you are saving, you need to compare apples-to-apples and the “monthly savings” portion of your post isn’t quite accurate. In order to calculate actual saved money, you should do the same calculations, but base your new payment on a loan length identical to the time left on your current loan.