In talking about refinancing, I recently mentioned the concept of the mortgage refinance “payback period,” which is the length of time that it will take to recoup the costs associated with refinancing. While there are a number of mortgage refinance calculators available online, I thought I’d give you a quick and dirty explanation of how to calculate your payback period.
Calculating your payback period
For starters, you’ll need to know how much it will cost you to refinance. You can get an idea of these costs by getting a good faith estimate from your prospective lender. Keep in mind that, for the purposes of this exercise, you should ignore escrow items such as taxes and insurance. The reason for this is that these amounts are essentially prepayments for items things that you will have to pay for whether or not you refinance. Moreover, you likely already have escrow funds encumbered with your current lender, and you will be receiving a refund following your refinance. As an aside, one way of reducing your closing costs is to request a reissue rate on your title insurance.
Once you know how much your refinance will cost you, you need to figure up your cost savings. To do this, compare your new monthly payment to your old monthly payment. To be sure that you’re comparing apples to apples, simply tabulate your principal, interest, and any applicable mortgage insurance under the two scenarios. Once again, you can safely ignore homeowner’s insurance and property taxes as you’ll have to pay those amounts under either scenario.
Once you have these numbers in hand, simply plug them into the following equation:
Payback Period (in months) = Closing Costs / Monthly Savings
As I’ve noted previously, the length of the payback period is an important factor in deciding whether or not to refinance your mortgage. If you can’t recover your closing costs in relatively short order, you might want to think twice about pulling the trigger. This is especially true if you’re not sure that you’ll be staying in your house for the long term.
Consider the total cost
Another wrinkle to consider is how much you’ve already paid on your current mortgage. If you’ve been in your home for awhile, then you’ve already sunk a good bit of money into original mortgage. In that case, you should also take a look at the total cost to own your home with and without the refinance. In other words, figure out how much you’d pay over the life of your original loan (without the refinance) and compare that amount to how much you would pay over the life of the new mortgage plus what you’ve already paid toward your original mortgage.
The bottom line here is that you need to be careful not to fall into the trap of lowering your monthly payment while increasing your total cost to own your home. I wrote a bit about this angle in an earlier article where we were considering whether or not to refinance our mortgage. In our case, we weren’t very far into our original mortgage, so it wasn’t a huge consideration. We ultimately pulled the trigger, though we also dropped from a 30-year to a 15-year term when we did it.