Refinancing a Mortgage

Refinancing your mortgage is a good idea if doing it saves you money, helps you pay off the mortgage faster (thereby building equity faster) or if you need cash for a worthy (according to you) reason.

The first one happens when you refinance at a lower rater; the second one when you get a shorter-term loan; the third one is self-explanatory.

Regarding the first one, I’ve seen articles stating that it is a good idea to refinance to get rid of mortgage insurance once you have 20% equity in the property.

By law, lenders must stop charging you mortgage insurance when you have 22% equity and you can request that they stop when you have 20%. (This would be determined by an appraisal or some automatic valuation method, so the point when you think you reached it and when the lender does might not be the same. But you and your lender’s appraising systems have the same chance of disagreeing about your property’s value if you refinanced too.)

When Is It A Good Idea To Refinance For A Lower Rate?

For a streamline rate-in-term mortgage application, the FHA rules, you can get a streamlined FHA refinance loan if the new loan will costs you (principal, interest and mortgage insurance) 5% a month less than the old one.  Or when you are switching from a risky one to a less risky one (from an ARM to a fixed-rate loan, for instance).

That seems like a good idea to me, if you add to it the costs of the getting a new mortgage into the mix.

This is pushed to an extreme, to make a point: if you save 5% (and that’s $150/month) on your mortgage payment and the closing costs are $1800 but you plan to own the property for only 3 more months, it clearly does not make sense as you’re spending $1800 to save $450.

Calculating the Break-Even Point For Closing Costs

To calculate your break even point, you divide the closing costs by the monthly savings.

If your closing costs are $2500 and your new monthly mortgage payment is $150 less than the old one, you divide 2500 by 150.

$2500 / 150 =16.67 months to break even.

That means, you really start saving toward the end of month 16.  Which means you should refinance only if you plan to keep the new loan for longer than 16.67 months.  The longer you keep it, the more you save.

If you keep the new loan for 3 years, 36 months, you’re saving $3049.50 ($150 x 20.33 months).

If you keep the new loan for 20 years, 240 months, you’re saving $33,495.50. Which is a nice chunk…  But here you must take into account the future buying power of money.  Still, even if buying power goes down, as it has been doing for a long time now, the savings is significant. (Unless the dollar collapses totally, World War III starts, aliens take over earth…  I mean, you don’t control the future, if it makes sense today and for the foreseeable future, stop with the paranoia and do it.)