Mortgage lenders often attract homeowners seeking to lower their mortgage interest rate with some simple math, usually presented in one of two ways:
1) Comparing the nominal closing costs to the total savings from 30 years of a lower monthly payment, or
2) How few months it will take before you break even with your refinancing closing costs due to lowering the monthly payment
Either way, the refinance looks very attractive: for a little cash up front, you can save far more money over the term of the loan. But don’t be fooled by the numbers – a lower monthly payment does not always mean saving more money, and it has little to do with the closing costs. The paradox can be explained easily by calculating the true total cost refinancing the loan. Let’s look at an example based on a typical refinance deal with Table 1 summarizing the key terms around the current loan and refinance offer.
Table 1: Current and Refinance Mortgage Terms
Looking at Table 1, the refinance offer for the lower rate of 4.47% looks like a great deal because you save $100 per month on the lower payments ($2150 – $2050). But this only paints a partial picture because it assumes that both loans are still for 30 years, whereas you have already paid off 2 years of the current loan. Here’s a breakdown of the numbers that you will see from most lenders brokers (column 1) and the numbers you really should consider (column 2):
Table 2: Refinance Calculation Costs
Most mortgage lenders and online refinance calculators will perform a ‘Refinance Savings’ calculation (the first column calculation in Table 2), drawing the conclusion that the refinance looks very favorable. After all, for just $3,000 in closing costs, you can save $33,500 over 30 years! And it would take just 30 months (or 2.5 years) to break even on closing costs, after which it’s pure savings. However, the ‘Real Cost of Refinance’ calculation (second column calculation in Table 2) shows the refinance clearly is a poor choice. Instead of saving money, you would actually lose over $15K over the life of the loan, even though your monthly payment is reduced. Worse, you would pay $3,000 in closing costs on top of your loss.
How can both calculations provide such different results? Technically, both calculations are correct; however, the ‘Refinance Savings’ calculation (Column 1 in Table 2) does not take into account the money you’ve already put into your current loan, or the fact that by refinancing, you are actually extending your loan for 24 more months. What this analysis tells us is that the farther into your loan you are, the lower the refinance interest rate and monthly repayment must be to make refinancing an attractive option. Don’t get fooled by simply looking into the top line monthly repayment number.
Finally, a simple Google search for “refinance calculator” will return many links to help you assess your refinance. However, the vast majority of these links do not offer the ‘Real Cost of Refinancing’ calculation as described in this post. While you can do the above calculations through Excel following the above logic, below is a free refinance calculator I found that does it for you. Incidentally, the calculations above are a short cut for estimating the actual savings/loss related to refinancing. To perform the analysis even more accurately, you must compare the total remaining interest on the current loan to the total lifetime interest on the refinance. Those formulas are a bit more complicated, but the results will be roughly the same as using the simpler approach above.
Remember, mortgage lenders and brokers earn revenue from the refinance, whether or not you save money – it’s in their best interest to ‘sell the refinance’ to you. So it’s in your best interest to perform the right analysis to ensure the refinance is truly right for you.