Should You Refinance Your Mortgage? Calculate Your Net Benefit to Find Out

(source)

Credit Sesame recently analyzed data from its user base and found out that, on average, homeowners who would qualify for a refinance based on their credit profiles, income and the equity in their homes, are foregoing thousands of dollars in savings over a 10-year period: from an average of $38,387 in Nevada to an average of $97,170 in New Jersey. Register today to see if refinancing could save you money.

With mortgage interest rates at their lowest in more than 50 years, many homeowners are asking themselves should I refinance?

After all, it's hard not to swoon at the thought of a 30-year fixed mortgage at 4.15% (the average rate for the week ending August 18, with 0.7 points, according to Freddie Mac), or 3.36 percent with an average 0.6 point for a 5/1 ARM.

With a $200,000 balance, a homeowner refinancing at those rates would get a $972 monthly payment at 4.15%, or $883 if they went with the 5/1 ARM. Assuming they currently have a 6% mortgage loan, a refinance would save them $227 or $316 a month, respectively. Heck, even if the original mortgage rate was 4.5%, they would save $41 or $130 a month.

But whether a mortgage refinance makes financial sense isn't solely determined by interest rates and monthly payments.

For years, homeowners have been conditioned into thinking that low interest rates are the main reason to consider a new mortgage – but all those radio and TV commercials don't tell the whole story.

One way to understand whether you are truly better off refinancing – or if you should spare yourself the trouble and stick with your existing mortgage – is by calculating the so-called net benefit.

What is “net benefit”? It's a way of forecasting your actual costs, payments and balances for years ahead, to see which home loan leaves you with more money in the bank.

Don't worry: it sounds more complicated than it really is. Here's how your can determine the net benefit of a mortgage refinance.

Can You Be Worse Off with a Lower Mortgage Rate after Refinancing?

Most people don't think that's possible, but the reality is that a lower mortgage rate does not necessarily mean an overall benefit to you. Here's an example.

Let's say your current mortgage rate is 4.5%. That's a pretty good rate, but the current mortgage rates are even better. Your loan officer tells you that he could refinance your mortgage to reduce your rate and lower your payment. You tell him that you're planning on selling your house in 13 years, so it may not make sense with all of the costs involved. Your loan officer says not to worry: he can get you a 30-year fixed at 4.25%--and he will take care of all of the costs. It's a no brainer: you get a lower rate at no cost.

Sounds like a good deal, right? Not necessarily.

Let's make a few more assumptions. For example, say your original home loan amount was $200,000 and you've had that loan for 10 years. (Yes, we realize that mortgage rates were higher than 4.5% a decade ago, but remember that we're using those numbers to help illustrate how net benefit works.)

So your current home loan has a payment of $1,013 per month. Over the past 10 years, you've paid the balance down to $160,179. If you refinanced your mortgage today to a 30-year fixed $160,179 loan at 4.25%, you will have a lower payment, $788 per month.  (There are plenty of online tools to calculate a mortgage payment based on loan balance and interest rate, you can use this mortgage calculator here at CreditSesame.com.)

So over the next 13 years, you will save $225 per month.  Lowering your mortgage payment is no doubt a good thing, because you can invest that money and make it grow. Let's assume that you put that money you save every month into a savings account earning 2% interest, and in 13 years it will grow to $40,047. (Use this calculator if you'd like to change any of those assumptions and figure out how much your monthly contributions will grow.)

So you will definitely have more money in your savings account that will come in handy when you retire, but that is only half of the story. The other half is what happens to your remaining principal balance. Thirteen years from now, your original loan would have a remaining balance of $72,904.  The refinance loan would have a remaining balance of $114,324. In short: your balance would be higher by $41,420.

The reason for this is the amortization schedule. On you original home loan, you had already gotten past the years of relatively little principal reduction and your loan was really starting to pay down. On your new home mortgage, the clock starts over and you revert back to a minimal principal pay down that occurs at the beginning of a 30-year loan. So while you were reducing your monthly mortgage payment with the rate, you were also reducing the amount of that payment that was going to principal.

Long story short: if you refinanced your mortgage, you would have $40,047 more in a savings account, but $41,420 less in equity.  Assuming you sell the property in 13 years as planned, you would be $1,373 worse off with a mortgage refinance than if you did nothing at all. It seems counter intuitive to most homeowners, but it's true.

The Point of Calculating Net Benefit When Considering if You Should Refinance Your Mortgage

If lowering your mortgage rate or monthly payment could theoretically make you worse off, how would you design a system that could account for this? That is one of the main purposes of calculating net benefit: using the actual costs and benefits of each loan, adjusted for your time horizon.

With mortgage refinance (or any refinance loan for that matter), it ultimately comes down to the difference between payments and closing costs, adjusted for time and the net effect on principal balance in the end.

So the next time a loan officer calls you to see if you are interested in refinancing your mortgage to today's low interest rates, ask him to calculate the net benefit for you. He'll probably tell you that he'll need to get back to you. If he does ever get back to you, ask him to run net benefit numbers with every other home loan product that is on the market today so you can compare.

Or sign up for an account at Credit Sesame to get your FREE credit score and use their patent pending financial tools to see how you can save money. That is exactly what we do, and we do it in seconds – free of any cost to you.