In a continued time of low rates, refinancing is a hot topic of conversation. People who mention it at a holiday party often find that friends and associates have refinanced already or are about to close. Because the process is so easy to start—you simply find your best rate and go from there—many people have dipped a toe in the refi pool, exploring their options.
Naturally, everyone wants a short list of things to look for. And not just the upsides, like a lower payment and a shorter term, but also any downsides.
Get Free QuotesObviously you know to look for a low APR and reasonable closing costs. Here we explain three less-obvious things you should watch out for when you consider a refinance and compare loans:
- Will you face a prepayment penalty?
- What is the breakeven point?
- Will you slide backward in debt?
Does Your Old Loan Have a Prepayment Penalty?
Some lenders charge a fee if you pay off your mortgage early. This compensates them for a little of the money they will lose when a borrower dodges years of interest by paying early.
The penalty is not triggered by small extra payments, which is great because you can save serious money paying $50-$100 extra each month. Selling the home or refinancing are two events that trigger the prepayment penalty.
If your old loan will impose this fee, you need to consider it when deciding whether refinancing will be financially worthwhile. Like closing costs, this fee adds to the price of the refi. Lenders have different formulas for calculating their penalty, whether it's a flat amount, six months of interest, or 1% of your loan balance. Whatever the penalty, it increases the price of moving to a refi.
The higher the price of the refi, the longer it will take you to break even. What is breaking even? We explain that next.
Will You Break Even Soon Enough?
A new loan will carry a price tag, referred to as closing costs. You may also face a prepayment penalty on the old loan. Any other charges or fees to secure the refi will add to the price tag. But you wouldn't even consider a refi if it wasn't going to save you money each month as well as serious interest over time. The breakeven point is the month when your savings finally offsets the price of the refi.
Breakeven Point = Closing Costs & Fees ÷ Monthly Savings
The formula looks simple, but closing costs aren't always what they seem. If you pay them up front, you pay face value. However, if you choose to roll them into the loan amount, they could cost you 25%-50% more in the end. To save the most money with any refi, pay the closing costs up front.
The breakeven formula above answers the question, "If I save X-dollars every month, how long will it take for me to recoup the closing costs?"
For example, if your old mortgage payment was $1,600 and the new one $1,375, the savings is $225 per month. Let's say you paid cash for closing costs of $4,000 and $2,000 as a prepayment penalty. This puts a $6,000 price tag on the refi. The breakeven point comes just before 27 months:
Breakeven Point = Closing Costs & Fees ÷ Monthly Savings
26.6 = $6,000 ÷ $225
Is 26.6 months good or bad? A breakeven point under 30 is good per money expert Clark Howard, whose assessment is echoed by others. The reason for the 30-month limit is that in three or four years, you want to be free to refinance again, not still paying costs associated with the last refi.
A breakeven point past 30 months probably indicates that the refinance is a better deal for the lender than for you. The lender would be making a lot of money off that loan, so much money that after 30 months you would still be paying the cost of setting up the loan.
Are You Adding Years to Your Debt?
Financial advisors discourage refinancing to a longer term. Although spreading your debt over a longer period will lower your monthly payment, it delays full homeownership. If a mortgage is a marathon, then adding years to your term is like running backward.
So if you have 22 years to go on your current mortgage, only consider refinancing for the same 22 years. Your term is customizable. Although you mostly see 15- and 30-year terms advertised, lenders can adjust the loan term to suit your needs.
Business owner Thomas Edmonds says, "Refinancing down in years, at a lower interest rate makes financial sense. Refinancing up in years at a higher interest rate is the mother of all no-nos. People who do things like this become the slave of the house rather than the owner of it."
Given today's low interest rates, there's no reason to move to a longer term. You can lower your payment and pay off the home when expected. And you might even be able to pay off the home sooner. Such is the power of really low interest rates. Let Lendgo help you find your best rate today.
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