When Refinancing Makes Sense

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filed under: Refinancing
If you decide to refinance, it helps to estimate the break-even point it takes for the refinancing decision to pay off. The break-even point is the number of months you need to live in your home after refinancing in order to recover the costs.
For example, if you pay $2,000 in closing costs to refinance and you lower your monthly payments by $100, it would take 20 months to reach the break-even point if you were to calculate it on a straight-line basis ($2,000/$100).
Say you bought your house five years ago. You borrowed $125,000 at a 10% fixed rate for 30 years. Your monthly payments for P+I are $1,097. You're thinking of refinancing your loan balance of $120,718 at today's lower rates. You want a 25-year loan, since you plan to be retired and living on less in 25 years.
The table below shows you can cut your monthly P+I payments to $1,013 if you can refinance at 9%. This is a monthly savings of $84 ($1,097-$1,013). If you face $2,000 in closing costs, you will break even if you live in your home an additional 24 months on a straight-line basis.
Years LeftLoan Balance9%8%7%
25$120,718$1,013$932$853
20$113,673$1,023$951$881
15$102,083$1,035$976$918
10$83,012$1,052$1,007$964

Let's look at another example. Say you decide halfway through your loan term to refinance. With an 8% interest rate, your monthly P+I payments on a refinanced loan balance of $102,083 are $976. This saves you $121 a month. Now your break-even point is nearer since you can allocate the same closing costs over fewer months. On a straight-line basis, you can now break even after 17 months.
In reality, a break-even analysis is more complicated. Nevertheless, a straight-line calculation gives you a reasonable estimate. One common rule of thumb is the 2-percent rule, which says that refinancing is a good deal if you can lower your mortgage interest rate by at least 2 percentage points. Other factors also ultimately affect your decision, such as how long you plan to continue living in the home. As mortgage rates go lower, this rule of thumb is less and less meaningful.
For a more complete analysis, you have to consider any loss of tax savings, as well as whether you invest the money you save each month from lower payments.
2008-07-21 15:28:03
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