Refinancing your mortgage to lower your interest rate by a percentage point definitely will shrink your monthly payment. Whether the reduction will be worth the hassle and the expense of refinancing, however, depends on your individual situation, particularly how long you plan to stay in your home.
How Refinancing Works
Refinancing involves taking out a new loan on your home and using the money to pay off the original mortgage. When you refinance, you can match the term that was remaining on your original loan — if you had, say, 25 years left on your first mortgage, you could get a new 25-year loan so the home will be paid off in the same amount of time. You also could refinance with a standard term, such as 15 or 30 years.
Dollar Value of the Reduction
How much a one-point reduction in your interest rate will affect your monthly payment depends primarily on the amount of the loan.
For example, say that your original mortgage was a 30-year loan for $250,000 at 6 percent interest. Your monthly payment for principal and interest would be $1,499, not including taxes and insurance. If you've been paying that mortgage for five years, your balance would be about $236,500. Now say you refinance that loan at 5 percent interest:
- If you stay on the same schedule with a 25-year loan, your new payment will be $1,382.
- If you refinance into a new 30-year loan, your new payment will be $1,270.
Over the course of the loan, these would add up to tens of thousands of dollars' worth of interest savings. The more you borrow, the larger the dollar savings from a one-point refinance would be. For example, if the original loan had been for $400,000:
- Your original monthly payment would have been $2,398.
- Your payment on a 25-year refinance at 5 percent would be $2,213.
- Your payment on a new 30-year loan at 5 percent would be $2,032.
Whether any dollar amount of monthly savings makes a one-point refinance worth the effort boils down to how much room there is in your monthly budget. For some, $100 might not be that significant; for others, it might be the difference between getting ahead and living paycheck to paycheck.
An online mortgage calculator can show you how much your monthly payment would be for any loan amount, interest rate and term. Your most recent mortgage statement should show you the remaining balance on your loan.
Understanding the Break-Even Point
Refinancing a mortgage typically involves extra costs paid at closing — for an appraisal, underwriting, paperwork processing and other services and documents. According to the real estate valuation site Zillow, the typical refinance has closing costs of $4,000. A refinance makes sense only if it saves you money overall — if the money you save on your payments winds up surpassing the extra costs incurred at closing.
You can use your closing costs and your monthly savings to determine the break-even point for your refinance. If refinancing saves you $117 a month, as it did in the original example, and your closing costs were $4,000, then it would take 35 months to recoup your closing costs. If there's a good chance you might not be staying in the house that long, a refinance probably isn't worth it.
Financing the Closing Costs
Closing costs don't necessarily have to be paid out of pocket. A lender may allow you to roll the closing costs into your new loan. Instead of, say, taking out a $236,500 loan and paying $4,000 in closing costs in cash, you could take out a $240,500 loan. If you go this route, it will affect your monthly payments, since you're borrowing more money.
Using the original example, financing $4,000 in closing costs as part of the new loan would reduce your monthly payments by about $93, compared with the original $117. At that rate, it would take you about 44 months to realize savings equal to your closing costs. You didn't pay the $4,000 in cash, but you did take on $4,000 in additional debt, so it remains a real cost to you.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.