Refinancing can often seem like a great way to lower your monthly mortgage payments and leave more money for other things. However, when weighing the pros and cons of refinancing, don’t forget to think about how this move could affect your net worth.
- A simple payment period method is often used to calculate the month that a homeowner’s accumulated savings exceed the cost of refinancing.
- A more financially sound way to calculate the cost of refinancing is to estimate the impact on your household’s equity.
- To know when an economic refinancing decision will be made, homeowners should compare the remaining repayment schedule on their mortgage with the repayment schedule on the new mortgage.
Why? A mortgage is more than a monthly payment. It is a debt instrument that is used to finance an asset. And that accounting professor’s jargon means that having a mortgage lowers your net worth.
This is how the reasoning works. In a family balance, there is a mortgage liability. Therefore, it is subtracted from the family wealth to determine your net worth. Too many consumers fall into the trap of refinancing a mortgage to lower their monthly payments without thinking about the impact of that refinancing on their overall net worth. Is Refinancing Your Home Worth It? Or is it just a short-term solution to a bigger problem?
Repayment period method
The most common method of determining the economics of mortgage refinancing is to calculate a simple repayment period. This equation is calculated by calculating the amount of monthly payment savings that can be made by refinancing a new mortgage at a lower interest rate and determining the month in which that accumulated amount of monthly payment savings exceeds the associated costs.
Suppose, for example, you have a 30-year home loan for $ 200,000. When you did, you received a fixed interest rate of 6.5% and your payment at the beginning of the month is $ 1,264. If interest rates are now set at 5.5%, this could lower your monthly payment to $ 1,136, resulting in a monthly savings of $ 128, or $ 1,536 per year. The typical rule of thumb is that if you can lower your current interest rate by 0.75% to 1% or more, it may make sense to consider refinancing.
Next, you will need to ask your new lender to calculate the total closing costs for the possible refinance. For example, if they hit $ 2,300, their payback period would be 1.5 years at home ($ 2,300 divided by $ 1,524). So if you plan to stay at home for two years or more, refinancing makes sense, at least using the simple payback period method.
What was missing in the repayment period method
However, this method ignores the household balance sheet and the total equity equation. There are two main things without an account.
Cost of refinancing
With the simple amortization period method, the principal balance of the existing mortgage against the new mortgage is ignored. However, refinancing is not free. Refinancing costs must be paid out of pocket or, in most cases, added to the principal balance of the new mortgage.
When a mortgage balance increases through a refinancing transaction, the liability side of the family balance increases, and when everything else is stable, the home’s equity immediately decreases by an amount equal to the cost of refinancing.
Total mortgage interest paid
Getting a lower interest rate on your refinance mortgage does not mean that you will pay less in total interest. For example, if a 30-year mortgage is refinanced with 25 years remaining until paid off on a new 30-year mortgage, you may have to pay more full interest over the life of the new mortgage. It all depends on how much lower the new interest rate is.
The home equity method
A more financially sound way to determine the economics of refinancing that incorporates real costs into the home equity equation is to compare the remaining amortization schedule of the existing mortgage with the amortization schedule of the new mortgage.
The repayment schedule for the new mortgage will include the refinancing costs in the principal balance. If refinancing costs are paid out of pocket, then for proper comparison, the same dollar amount should be subtracted from the existing mortgage principal balance. This is based on the assumption that if the refinance transaction does not go through, the money you would disburse for expenses could be used to pay off the principal balance of the existing loan.
Subtract the monthly payment savings between the two mortgages from the principal balance on the new mortgage. This is because, in theory, you could use the monthly savings generated by the refinance to reduce the principal balance on the new mortgage. The month in which the modified principal balance on the new mortgage reached the principal balance on the existing mortgage is the month in which a truly affordable refinance repayment term was reached, based on the net worth of the home.
By the way, amortization calculators can be found on most mortgage related websites. You can copy and paste the results into a spreadsheet, then do the additional calculation to subtract the monthly payment differences from the principal balance on the new mortgage.
Example of the home equity method
Using the above calculations, the refinance analysis of an existing mortgage with a fixed interest rate of 7%, 25 years remaining until paid, and a principal balance of $ 200,000 on a new fixed interest 30-year mortgage of 6.25 % and refinance costs of $ 3,000 (to be included in the principal balance of the new mortgage) give the following results:
If a simple pay period analysis is used to determine the economics of refinancing in the example above, the savings accumulated in the monthly payment exceed the costs of $ 3,000 to refinance beginning in month 19. That is, the period method Simple payment tells us if the owner expects to have the new mortgage for 19 months or more, refinancing makes sense.
However, if the equity approach is used, the refinancing decision will not be economical until month 29, when the balance of the principal of the new mortgage minus the savings accumulated in the monthly payment will be less than the balance of the principal of the existing mortgage. The equity approach tells us that it takes 10 more months than the simple payback period approach before refinancing is economical.
If you refinance after losing your home equity and have private mortgage insurance, the negative impact on your net worth could be even more substantial.
Keep in mind that during periods of declining home values, many homes are priced much lower than before. This may mean that you will not have enough equity in your home to meet the reduced 20% payment on the new mortgage, requiring you to create a larger cash deposit than expected.
It may require you to have private mortgage insurance (PMI), which will eventually increase your monthly payment. In these cases, even with lower interest rates, your actual savings may not be much.
By calculating the actual refinance economy of your mortgage, you can pinpoint the payment period you have to compete with. It takes a bit of work to boost the numbers, but anyone can do it.
Especially if you plan to move in the next few years, if you take a few minutes to calculate the actual refinancing economy of your mortgage, it can really help you waste thousands of dollars. And if refinancing is likely to pay off, you’ll have a better understanding of when to start taking advantage of this measure.