Interest rates have tumbled. Refinance your home loan?

June 18, 2001

Fed Chairman Greenspan may have handed you a golden opportunity to save. First, though, grab your calculator.

 

Interest rates have tumbled. Refinance your home loan?

Jump to:Choose article section... How to figure out if refinancing is worth the money How long will it take to break even on a new loan? What will your total savings be?

Fed Chairman Greenspan may have handed you a golden opportunity to save. First, though, grab your calculator.

By Susan Harrington Preston
Senior Editor

If you missed your chance to refinance your home loan during 1998's interest rate dip, you have another opportunity to get low rates now.

That opportunity may be well worth taking—but don't just assume it is. A refinanced loan is a new loan, complete with all the up-front costs, while the money you save on house payments accumulates in a trickle, month by month. To make a new loan worthwhile, you have to live in your house long enough for the savings to exceed the costs of refinancing.

You're apt to find refinancing useful if:

• You've paid down the equity on a jumbo mortgage to the point where you can replace it with a lower-cost conventional loan, meaning a mortgage of $275,000 or less.

• You've got an adjustable-rate mortgage, and you can switch to a modestly priced, fixed-rate loan with payments you know won't rise.

• You can afford slightly higher payments, so that you can, say, replace a 30-year mortgage with a 15-year loan that will cut down on the total interest you'll pay.

• You're paying private mortgage insurance now, but you won't have to after refinancing because your equity will have grown to more than 80 percent.

Unfortunately, no simple calculation will tell you exactly how much you'll gain or lose by refinancing, because so much depends on the specifics of the old and new loans. For instance, when you refinance, you reset the amortization clock, so you'll pay more in interest right at the start than you would have if you'd kept the old loan. That, in turn, should beef up your tax deduction for several years, but it also slows your equity-building. Then again, you'll probably borrow less with the new loan than you did with the old one, or you'll have a loan length with fewer months to run. Either will save on overall interest costs.

Since not all mortgages are created equal, you'll need to shop around to find the best terms—and it wouldn't hurt to check up on your credit score as well.*

Once you've settled on two or three new mortgages that seem to offer what you're looking for, you don't have to make yourself crazy over a calculator to turn thumbs up or thumbs down on a new loan. You only have to ask yourself, "Starting now, which mortgage is likely to cost me the least in the long run?" The charts below will help you answer that question.

You can also consult Web sites with mortgage calculators, such as www.ewmortgage.com, or use a financial-planning program such as Quicken. And if you're still unsure about committing real money to refinancing, check with a financial adviser.

How to figure out if refinancing is worth the money

Ask yourself two questions: How long will it take until I break even on the new loan? And how much will I save over the life of the new loan?

Follow the first three steps for a preliminary answer to the first question. (If you plan to replace your old loan with a loan that has a shorter term and bigger payments, skip this part and go on to steps 4 and 5.)

We've plugged in sample numbers so you can see how the calculations might play out. In this example, a 20-year loan of $450,000 at 6.8 percent will replace a hypothetical 30-year loan of $500,000 at 7.8 percent on which the borrower has been paying for 10 years. The new loan requires the borrower to pay two discount points up front. It will take about six years—73 months—before the new loan begins to pay for itself.

How long will it take to break even on a new loan?

Step 1: Find the up-front costs on the new loan. When comparing your current loan with a new one, don't count the up-front costs of the original mortgage. That's because it's history—you can't get that money back. You do, however, have a choice about whether you're going to incur such costs again by taking out a new loan.

Points on a refinanced mortgage are deductible over the life of the loan and are built into the monthly payment, but for simplicity they're translated here to dollars paid up front.

 

Fees$2,000 1,000 9,000 12,000

 

1Fees may include application, title search, appraisal, origination fee, credit-check fee, attorney's fee, and transfer fee. You'll have to get a total for all fees when you evaluate a new loan offer. Our $2,000 total is an approximation. 2You may not have to pay a penalty for prepaying your old loan, but we've included one here for illustration purposes.

Step 2: Find the difference in monthly payments. We're assuming you won't have to pay private mortgage insurance on either loan. If you will, include the premium in the monthly payment.

 

Old loan New loan Difference$3,599 3,435 164

 

Step 3: Find the number of months until you break even on a new loan.

 

Up-front costs Difference in monthly payments Months until you break even on the new loan*$12,000 164 73

 

What will your total savings be?

Do you expect to be in the house for more than 73 months? If so, refinancing may be worth your while. But you won't know for sure until you figure in the effect on your taxes. Usually, if your new loan won't last longer than the number of months left to pay on your old loan, you'll pay less in taxes because of the change in your loan-amortization schedule. The charts below will give you a general idea of your savings over the life of the loan.

Step 4: Get a rough idea of the tax effect.

 

Total of all loan payments Principal Total interest Interest already paid Interest not yet paid Future tax writeoffs* Difference in tax writeoffsOld loan $1,295,770 500,000 795,770 368,720 427,050 169,112New loan $824,400 450,000 374,400 0 374,400 148,262 20,850

 

Step 5: Sum it all up.

Interest yet to be paid Interest saving on the new loanOld loan $427,050New loan $374,400 52,650 (20,850) 31,800

 

*See "Improve your credit score—and pay less for a loan," May 21, 2001.

 

Sue Preston. Interest rates have tumbled. Refinance your home loan?. Medical Economics 2001;12:57.