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The Math of Refinancing

I used to think the concept of refinancing one’s mortgage was simple, but lately, I’m not so sure. Let me take you through the process with an example of how I’d approach this. You have a balance of $250K on your mortgage and are paying 6%, Your payment is $1791.

You find a 5% mortgage, and the payment is $1342. Wow, nearly $350 per month savings, right? A $3500 closing cost doesn’t look too bad, a 10 month breakeven. Ok, time to think about this. What’s missing? Well, when you told me the payment is currently $1791, I calculated you have 20 years left, on a mortgage that started at nearly $300K. So to understand the savings, you should look at the new rate, but use the remaining time from the old mortgage, got that? In other words, even though it’s a new 30 year mortgage, calculate the payment with the new rate, but a 20 year term. That will give you $1650. This is you actual savings, $140/mo. The $350/mo we first calculated comes at the expense of ten more years of the mortgage. The savings produce a breakeven of 25 months. This may still be worth going after, but it’s far less than you thought, and if you have any idea of moving before then it may not be worth the refinance. Any questions on this approach, post a comment, let me know.

Joe

  • Augustine June 15, 2010, 9:54 am

    Joe,

    That’s what I did in my refinances. At the first one, I had 25 years left and asked to refinance while keeping the payment the same, so the term went down to 20 years. The second time, I had 16 years left and, thanks to the lower rates, I knocked $100 off of the monthly payments and the term went down to 15 years.

    However, in this day and age, I’d suggest that it’s not a bad idea to refinance at 30 years and make the same payments as before, even at a higher interest. Then, if one loses his job, he can fall back to the term payments until he finds another job, when he’d resume the higher payments.

  • JOE June 15, 2010, 10:07 am

    There’s a balance between doing all you can to kill all your debt and staying flexible in case of a job loss. Your point is well taken. We are at historic lows on the 30 year rate, not a bad idea to take it, and benefit from paying back with cheap dollars when inflation returns.

  • James June 16, 2010, 4:59 pm

    i used to do mortgages and refinances and the first question i would ask people was do you plan on living in your house for 30 years?

    at the end of the day everyone has different goals and if you are planning on staying in the house refinancing and going back to 30 years is not the best option if only sets you back…

  • Roshawn @ Watson Inc June 16, 2010, 10:04 pm

    @Augustine I get your point. If one keeps adequate liquidity though, then it would probably be okay to refinance and shorten the length of the loan..

  • Evan June 16, 2010, 10:45 pm

    Joe,

    Luckily there are those that already created calculators on the topic:

    http://dinkytown.com/java/MortgageRefinance.html

    I think this takes into account your concerns.

  • JOE June 17, 2010, 10:57 am

    The site has quite a few options, it wasn’t obvious at first how it was calculating, but it takes my point into account, as well as cash flow, i.e. same rate but longer term. Nice find, Thank-you

  • Financial Samurai June 17, 2010, 11:56 pm

    Yep Dinktown is a good site to calculate some random assumptions.

    I try and pay down 1-6 months of principal once a year to comfortably pay the mortgage down.

  • Doni June 25, 2010, 12:25 pm

    you make a great point and i totally agree most people miss the boat on this and only think of the short term fix.

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