How do I know if I should refinance?

Jason Kauffman | October 1, 2022

Once you become a homeowner, there is a high likelihood that you will have to make a decision about refinancing your home loan at some point in the future. Understanding the refinance process and how to assess the benefits and setbacks that factor into deciding whether or not to refinance will help you make a sound financial decision when the time comes.

What is the benefit of refinancing?

Any time you are contemplating a refinance you need to determine what your goal of the refinance is. Below is a list of common reasons people decide to refinance:

  • Lowering your Interest Rate
  • Lowering your Monthly Payment
  • Removing mortgage insurance
  • Taking cash from the equity in your home
  • Consolidating other loans into a fixed payment
  • Pulling out money to renovate your home

If you are in the refinance process and you don’t understand what the benefit of the refinance is, you need to talk to your mortgage professional and get more information. Without a significant benefit, refinancing your home is a waste of your time and money.

How much do I need to lower my rate to justify refinancing?

When the goal of your refinance is to lower your rate, a comparison should be made between the current rate (and interest) that you are paying and the new rate and interest on the new loan. Often homeowners will try to compare old payment versus new payment. This approach tends to muddy the waters because it includes principal and interest, compared to just comparing the interest amounts.

If you were to switch from a 30 year fixed loan to a 15 year fixed loan, your payment is going to go higher because you’ve shortened the term. This increase has nothing to do with the interest rate and everything to do with how quickly you pay the loan in full. Looking at the difference in interest cost is the first step in rationalizing a refinance.

The second step of any refinance consideration is the cost. How much is this refinance costing me? Once you know the cost and the interest savings you can run a calculation on how quickly you are able to recoup the cost. We call this the breakeven point.

This is the formula to calculate the breakeven point:

Cost to Refinance ÷ Monthly Interest Savings = Number of Months to Breakeven

Example:

Old Loan Balance: $450,000
Old Loan Rate: 7%
Monthly Interest Calculation: $450,000 x .07 ÷ 12 = $2625 in monthly interest

New Loan Balance: $460,000
New Loan Rate: 5.5%
New Loan Cost: $5,000
Monthly Interest Calculation: $460,000 x .055 ÷ 12 = $2108.33 in monthly interest

Cost $5000 ÷ Interest Savings ($2625 – $2108.33) = 9.67 months to breakeven

Using this calculation, you’ll discover that there really isn’t a specific rate reduction required to justify a refinance. If you were able to refinance for no closing costs and only lower your rate by .125% it would likely make sense.

As a consumer, you should be considering three things: the cost to refinance, the interest savings, and how long you intend on keeping the home. If you wanted to refinance and it had a 3-year breakeven point, but you knew you were going to sell your home and move in 2 years, you shouldn’t do that refinance. Your timeline to own the property needs to marry with the breakeven point on the refinance. Otherwise, you’re spending money to get savings that you’ll never realize because you’ll never recoup the cost.

What are the other reasons to refinance?

If you are not refinancing to save money on interest rate then you are likely taking money from the equity in your home with some purpose in mind. You may be looking to pay off high interest debts. Maybe you are looking to consolidate a first and second mortgage into one. Perhaps you are trying to fund a renovation project for your residence to increase its value.

No matter what your reason is for wanting to pull cash out you should be examining all possible options.

Often doing a cash out refinance is not the most cost-effective way to access the equity in your home. There are many situations where leaving your existing first mortgage, that has a competitive rate, in place is more sensible. There are many banks that will do a Home Equity Line of Credit (HELOC) as a second mortgage. Depending on your first mortgage rate and terms, a second mortgage can allow you to access equity in your home while preserving a low rate on your existing mortgage.

You have to examine it using a calculation like the one below:

OPTION A

Current Loan Balance: $400,000
Current Loan Rate: 3%
Monthly Interest Calculation: $400,000 x .03 ÷ 12 = $1000 in monthly interest

New HELOC Balance: $100,000
New Loan Rate: 7%
Monthly Interest Calculation: $100,000 x .07 ÷ 12 = $583.33 in monthly interest

Current Loan + HELOC Interest = $1583.33 in monthly interest

OPTION B

New Single Loan Balance: $500,000
New Single Loan Rate: 5.5%
Monthly Interest Calculation: $500,000 x .055 ÷ 12 = $2291.66 in monthly interest

Option A versus Option B: $1583 vs $2291 in monthly interest

This illustrates how you can determine if it doesn’t make sense to do a cash out refinance when a HELOC might be a better financial decision.

The discussion of whether or not to refinance is going to happen for just about every homeowner. The most important thing is that you are working with a mortgage professional that can help you understand the decision you’re making and work with you to identify the benefits and costs associated with the refinance.

Jason Blog Bio

Jason Kauffman

Jason Kauffman is one of the owners of Uptown Mortgage and a licensed mortgage originator. He is a veteran in the mortgage industry with over 20 years of experience helping people get financing on their homes. The same experience that he brings to his clients is what he brings to the mortgage content that he produces. His goal is to help educate current and prospective homeowners on subjects that are relevant to the homebuying process.

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