NEW YORK (MainStreet) - While different methodologies produce slightly different results, all mortgage surveys show that rates are extraordinarily low right now, making refinancing look awfully attractive. But many mortgage shoppers overlook a key factor that grows in importance as they refinance to a new rate: closing costs.
Years ago there was one simple rule of thumb on refinancing: It could pay if the borrower could slash the loan rate by two or more percentage points. But in recent years borrowers, lured by online comparison shopping and easy application processes, have often refinanced to save only one percentage point, sometimes less.
The problem is that while mortgage rates have plummeted, closing costs like title insurance, transfer taxes, appraisals and application fees have stayed about the same, typically at a little over 2% of the loan amount. If the refinancing reduces the payment by only a small amount, it will take longer for those savings to offset the closing costs.
Imagine a borrower refinancing a $300,000 loan taken out in the fall of 2008, when 30-year mortgages charged about 7%. Today the borrower could refinance the balance of the loan, about $290,000, with a new 30-year loan at 4% interest. By saving about $600 a month, the borrower could offset $6,600 in closing costs in a mere 11 months, according to the BankingMyWay Refinance Breakeven Calculator.
But suppose the original loan had been taken out only a year ago, at a rate of 5%. Refinancing to 4% would save about $200 a month, and it would then take 34 months to break even.
All that’s fairly intuitive, and the longer break-even time is no problem if you plan to stay in the home for at least 34 months. But refinancing clearly would not pay if a new job, a baby, marriage or some other unexpected event forced a move during the next three years. If you were forced to relocate, you might wish you still had those thousands of dollars you spent on closing costs.
For a clearer look at your options, try the calculator, as a number of factors can change the results, such as your tax bracket. Note that there are four ways to figure out the break-even period, depending on assumptions you make about taxes or alternatives such as using cash to pay down the existing mortgage instead of spending it on closing costs. Click the “View Report” button for a detailed analysis, and look at the figures for total interest costs over each loan’s life.
Keep in mind that if you refinance a 30-year loan that you’ve had for five years with a new 30-year loan, some of your savings will be offset by interest charges for those extra five years. If you expect to stay in the home for the long term, the new loan should be set to be paid off on about the same date as the old one.
Don’t forget to make closing costs a key factor in your loan shopping. Once you’ve found a few lenders with attractive rates, call them for details on costs, and keep in mind that some lenders will waive fees if you just ask them to.
While mortgage rates are low across the board, getting approved for one is more difficult than it used to be. Check out MainStreet's look at alternatives with Seller Financing: A New Way to Buy Your Home.