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How far does the Interest Rate need to drop?
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When is it worth looking into refinancing based on how far the interest rate
has dropped?
The simple answer is how long will it take to recapture what it cost.
This is probably one of the most misrepresented concepts out there. I have
heard borrowers tell me everything from 1/2% to 3%! The real answer is that
you should not be looking at the interest rate alone. Combine all the factors
involved and see if it actually saves you money.
How can they all have heard such a wide disparity?. The best answer that I
can give for that is that all those answers are probably right for different
borrowers in different situations. Rather than looking at their own situation,
they have read an article about another situation.
The different answers are almost always a direct result of the cost of the
new loan.
Generally, 1/2% is worth crunching the numbers when you are working with a
mortgage banker who is treating you fairly and with integrity. If it only
costs you the time to go in and sign papers, this figure may be lower.
What are you trying to accomplish?
Are you looking to have a lower payment?
Are you looking for a lower interest rate cost over the life of the loan?
Are you considering shortening the length of the loan?
What else could you do with the money it costs to refinance? Can you make
more than you will save?
Is this really going to save you money?
The closing costs, the years you are adding to your loan, what you will do
with your house are all factors which must be considered, not just whether
you are ending up with a lower interest rate.
The 4 factors you need to compare are
Your payment.
Your cost to refinance
How long will you stay in your home.
How long have you had your current loan?
Your payment
The first one is simple. Will your payment be lower than it is now?
The cost to refinance.
Many people refinance and add the costs of the new loan into the balance rather
than coming up with the funds to close the loan. If you keep this loan for a
long time, you will be paying interest on these costs for the life of the loan.
Does this really make sense?
One great way to reduce those costs is that in a refinance, you essentially
skip a payment due to the prepaid interest on your new loan. Seriously consider
making that payment at the closing that you will miss and reduce the amount
you add to the loan balance.
A little creativity here and a helpful mortgage professional can give you many
choices as to what the costs will be. This is often a great time to ask about
a no-cost loan or a reduced cost loan.
Ask what the rate is for a no cost loan and compare. Another way to pay less
costs is to ask how much of the costs your mortgage person will pay if you take
1/8% higher in the rate. This can be up to 1/2 a point and will pay quite a
bit of the costs for you. If the loan only costs $300 or $400 you can make up
the savings quite quickly.
How Long will you stay in your home?
This is an important factor in determining how far the rate needs to drop. You
need to calculate the savings per month and see if you end up ahead based on
how many months you will be staying.
I advise most borrowers to look at what will happen to them in the next 5 years.
For the majority of people, situations will change in 5 years, so the goal is
to be the person who pays the least amount of interest over a 5 year period.
Not sure that's true? Look back to 5 years ago and ask yourself if you are exactly
where you thought you would be now!
How Long have you had your current loan?
This is most important for those borrowers who will not refinance again. You
must consider it a cost if you will make 2 or 3 more years of payments than
you will be making now.
Examples
Here are two scenarios where different borrowers used two different methods
to accomplish their goals. Different goals lead to a different approach.
Here is an example that looks out 5 years.
The Smith's have a $200,000 mortgage at 6.75%, refinancing will cost them $1,500
and they know they will be staying in their home for at least the next five
years.
They can refinance today at 6.25%, lowering their interest rate by 1/2%.
Their current payment is $1,297.20 for principle and interest.
At 6.25%, that payment would be $1,231.43
The savings is $65.77 per month.
In just 23 months they will have saved more than the cost of refinancing!!!
In 5 years, they will have kept $3,946.20 in their pockets.
Here's an extra bonus to the Smith's.
After 5 years at 6.75%, they would owe $187,751.15 on their home.
After 5 years at 6.25%, that balance would be just $186,674.79.
They also have an extra $1,076.36 of equity for a total savings of $5,022.56
for their $1,500 refinancing costs. The Smith's have more than doubled their
investment in 5 years.
How many other places can you spend $1,500 to get $5,000 back?
Well, consider this. If you put $1,500 in the stock market and average a 15%
return for 5 years, your investment is only worth $3,017.
Here is another example with reduced costs, but a higher
rate.
The Jone's also have a $200,000 mortgage at 6.75%, but the Jone's are not sure
whether they will be in their home for 5 years or not, so they take a higher
interest rate.
By taking an interest rate of 6.375% (1/8% higher than the Smith's) their mortgage
professional is able to give them a rebate against their closing costs of 1/2
point or $1000. Therefore, the closing costs for the Jone's are only $500
Their current payment is $1,297.20 for principle and interest.
At 6.375%, that payment would be $1,247.74
The savings is $49.46 per month.
The Jone's have recaptured the closing costs of $500 in just 11 months. If they
sell their house in even one year it has not cost them any money and after the
first 11 months they will save $593.52 per year that they keep the home.
Even if they end up keeping the house for 5 years they will still have taken
their $500 investment in refinancing and saved $2,423,54 on their mortgage.
Side by side comparison
Now, lower costs always sounds like the better deal, but as they always say,
it takes money to make money and this is a perfect example of that.
This chart shows the total savings year by year for both the Smith's and the
Jone's and how it makes more sense to take the lower interest rate if you are
keeping the home for some time.
Since the Smith's save $789.24 a year, and the Jone's are saving $593.52 a year,
the extra $1000 of closing costs gets eaten up over time so that if the Smith's
keep the home longer than 5 years they are in the best position financially.
However, if either family keeps the home for less than 5 years, the lower costs
are the way to go.
Note that fter 11 years, the Smith's have saved recaptured the extra $1,000
they spent up front AND saved an extra $1000.
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Total
Savings at the end of each year
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| Family |
Year
1
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Year
2
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Year
3
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Year
4
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Year
5
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Year
6
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Year
7
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Year
8
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Year
9
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Smith
6.25%, $1500 costs |
-710.76
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78.48
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867.72
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1,656.96
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2,446.20
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3,235.44
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4,024.68
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4,813.92
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5,603.16
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Jones
6.375%
$500
costs |
93.52
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687.04
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1,280.56
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1,874.08
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2,467.60
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3,061.12
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3,654.64
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4,248.16
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4.841.68
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Summary
The bottom line is that there really is no simple answer. It must be a combination
of the closing costs and the savings per month and how long you will keep the
loan.
However, if you can lower your interest rate by even a quarter percent and it
costs you nothing to do it, then take advantage of the savings.
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