Learn When to Refinance a Mortgage

Consumers who want to save money and have a mortgage should consider refinancing. Conventional wisdom is that consumers should refinance if there is more than a two percent reduction in interest rate, but borrowers need to consider other aspects.

Reducing Payments by Refinancing

The first step in determining whether to refinance is pull together the pertinent data. The information needed includes:

The current interest rate, unpaid balance and term (years remaining)The new interest rateCosts associated with the financing, including points

Microsoft Excel has an easy function to determine payments based on the above information. Consider the following example:

The current interest rate equals six percent on a balance $100,000 with 2 years remaining. The payment on this loan is $716 per month. If the refinancing rate is five percent, and $5,000 of closing costs are paid separately, the rate drops to $693.

If would seem logical to refinance, but there the closing costs are a factor to be considered. A simple way to look at it is if the bank or mortgage company offers to roll the closing costs into the mortgage. This way there are no out of pocket costs.

The refinanced balance of $105,000 (mortgage plus closing costs) at five percent yields a payment of $673. Now consider if the closing costs were $10,000. The payment rate would $725, which is more than the original payment. On the same note, if the interest rate were 5.5% with the original $5,000 closing costs, the payment would be $722, and refinancing would be a bad idea.

It is not possible to choose an amount where it always preferable to refinance, since it depends on the term remaining, the interest rate difference and closing costs.

Other Considerations for Mortgage Refinancing

Rather than looking at the interest rate difference, it makes more financial sense to look that relative change in the rate. For example, the difference between ten percent and nine percent is one percent.

The difference between 6% and 5% is also one percent, but the relative change from 6 to 5 is 16%. The relative change from 10 to 9 is 10%. Bringing the rate down by a relative change of 16% is much better than 10%, and will make a substantial difference in the calculation.

A complicating factor is that borrowers may have the option of changing terms when refinancing, either by adding or reducing years to the term or by increasing the amount owed (a cash-out mortgage).

Changes will distort the calculation, so consumers should look at the transaction before adjustments to see if it makes financial sense. Borrowers may still want to go ahead with the cash-out even if payments increase is the they want the additional amount of money, for example to pay off higher rate credit cards.

Refinancing a mortgage is almost as important a decision as buying a house, and consumers should be well aware of the financial implications.

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Tags: Mortgage   Posted in Debt Consolidation