Calculating the benefit of refinancing can be a challenging task if you do not understand what to calculate. We are going to focus on the benefits of refinancing from the standpoint of lowering your interest rate.
Calculating the actual savings can be a tricky chore unless you know the difference between cash flow savings and interest savings. If your refinance objective is to only save on the interest by lowering your rate, then the interest savings should be done with the calculations below.
Calculating Interest Savings:
Current Interest Payment (Loan Amount x Interest Rate) / Months in year = Interest paid per month
($200,000 x 6% or .06) / 12 = $1,000.00 *Remember to do the calculation in the parentheses first*
So you are paying $1,000.00 per month in interest.
Now take the new interest rate you are getting with your refinance and calculate what your new interest payment will be.
($200,000 x 5% or .05) / 12 = $833.34
Now we need to find out the difference between the two interest rates.
Current Interest Payment – Proposed Interest Payment = Interest Savings
$1,000.00 – $833.34 = $166.66
Dropping your interest rate 1% on $200,000 will save you $166.66 per month or about $2,000 per year! So you will want to proceed, right?
Not so fast, you need to calculate the “break-even” point to find out how you will benefit after your closing costs.
Net Benefit Formula (Break-Even):
Closing Costs / Interest Savings = Month of Break-Even
$6,000 / $166.66 = 30 Months
So it will take 30 months for you to recoup the cost of your refinance. If you plan to keep your mortgage for at least 30 months, then consider this deal.
One more calculation, say you stay in your home for 10 years
(Monthly Savings * Months you plan to keep mortgage) – Closing Costs = Net Savings
($166.66 * 120 months) – $6,000 = $14,999.20
If you kept the mortgage for 120 months (10 years) you would save $15,000. Okay, now you can find out where to sign!
Calculating the net benefits of a refinance is crucial in determining if it is strategic for you to refinance. Keep in mind that each mortgage is slightly different and you may need to adjust calculations accordingly.
Frequently Asked Questions:
Q: I heard that I should only refinance if I drop 1% on my mortgage is that true?
1% is just a “rule of thumb”, it will depend on a number of factors, such as how long do you expect to stay in your home, how much do you owe, etc…
Q: Why can’t I just compare my current payment to the proposed payment and figure out my net benefit?
You could just compare just the two payments if you wanted to find out your cash flow savings, but the current and proposed loans may have two different amortizations.
Let’s assume you currently have a 15 year mortgage and you’re comparing it to a 30 year mortgage. If both loans have the same interest rate and loan amount but the amortization is different, your interest savings per month would be $0. However, you are going to show a cash flow savings with the 30 year mortgage because of the longer amortization.