When it comes time to decide when to consider refinancing your home, one of the biggest questions you need to ask is whether it will be worth the initial investment. You’ll want to determine what your break-even point is, which is the point at which your monthly savings equals your closing costs.
The basic formula is your total closing costs divided by your monthly savings. (maybe have an image/infographic here displaying the actual mathematical formula visually?) The number that results is the number of months it will take for the monthly savings of your refinance to equal the amount you invested in your closing costs. The general rule is that you want your break even point to fall within two years of refinancing your mortgage, but this guideline can be adjusted based on a number of factors. For example, if you plan to sell your home within the next few years, a refinancing with a break even point of more than 18 months probably isn’t worth the trouble.
There are also four other factors to consider on top of your closing costs:
Your original lender may have included a prepayment penalty as part of your mortgage, some lenders will check for you, and include this fee in your closing costs, but not all provide this service. It’s important to check for penalties before you consider refinancing, as they can sometimes be as high as a half a year’s worth or mortgage payments.
PMI (principal mortgage insurance) is charged for loans that originated with less than 20% down. If you pay PMI on your current mortgage, and/or if your equity is under 20%, PMI will likely carry over into your new loan. PMI is usually assessed at 0.5% of the principal balance each year, but can be as high as 1.5%.
One of the many possible goals of refinancing is to shorten the term of the loan, in turn decreasing the amount of interest paid over time. Not everyone refinances with this goal in mind, and some options will actually increase the term of the loan, which could mean that you end up paying more money toward interest in the end.
If your new loan results in a longer pay-off term, an enhanced refinance may negate any additional interest accruals. An enhanced refinance means that you pay a little extra each month in order to pay off the new loan at the same time your old loan was set to be paid off.
The last thing to consider is how your new interest rate may affect your taxes. If you claim or deduct interest when you file your taxes, a lower interest rate could result in a lower deduction, which could affect the amount you are returned or the amount you owe. Your taxes are generally not affected heavily by a mortgage refinance, but it is definitely a factor to consider alongside closing costs and your break-even point.
The formula above sounds quite simple, but when you get down to it, there are a number of factors that are involved in calculating the total amount of out-of-pocket expenses required to refinance your home. There are several different types of fees that can be associated with your mortgage refinance:
The first amount you’ll be charged is an application fee, also sometimes referred to as an underwriting fee. This amount covers the cost to run your initial loan application and your credit reports. It may also include charges for an appraisal and/or various administrative fees. Application fees vary widely by lender or organization, but you can generally expect to pay somewhere between $100 and $500. If your loan request is denied, you are not likely to be refunded this fee.
The origination fee, also known as a loan processing fee, is charged by the lender to cover the cost of evaluating, qualifying, and preparing your new loan. This fee is usually 1% of your total loan amount, but it can range from 0.5% to 1.5% depending on the lender and the terms.
A point is equal to 1% of your loan amount. Ideally, you should have the option to pay points up front in an effort reduce the interest rate and term of the final loan. These types of optional points are considered loan discount points. Some lenders actually charge points in the initial loan agreement, and are not an optional part of the process.
Some lenders include the cost of appraisal as part of the application, while others charge a separate fee. Either way, an appraisal is necessary in order for the lender to ensure that your home is worth enough to justify the amount of the loan. Appraisals play an important factor in determining whether or not you even qualify to be refinanced, so keep this in mind when applying. An appraisal might also help exempt you from PMI. If your home’s value has increased enough to place your loan-to-value ratio over 80%, you can contest having to pay PMI on your new loan.
You are legally entitled to copies of any appraisal your lender has done, but you will often have to request this information. While every lender will include an appraisal as part of the qualifying process, it is recommended that you have your own appraisal performed by an independent third party to ensure that no one’s interests are being catered to when determining the value of your home. If you have already had an appraisal done recently, your lender may be able to use that information in the loan process. This could save you from having to pay an appraisal fee, which can be anywhere from $300 to $700.
These fees apply to the cost of searching the property’s records, and title insurance to protect the lender’s investment if any errors occur during this process. The search and examination are done to ensure that you are the rightful owner of the property, that the information on the title is all true and accurate, and that there are no additional liens on the property. These fees can be anywhere from $150 to $700, and are often waived if you are refinancing through your original lender.
Survey fees cover the cost of having your property surveyed to confirm the location of structures and assess any improvements or additions made to the lot. This information is pertinent to the loan process, to protect both lender and homeowner from fraud, and to ensure that any errors in the title or deed don’t cause issues or delays before closing. Survey Fees can range from $100 to $400.
You may have to pay one or more inspection fees, depending on your lender and where you live. Some states require certain inspections for things such as pests and mold, while others require flood certifications. Lenders may also opt for certain types of inspections, including septic and structural integrity checks. Inspection fees are difficult to predict because there could be many or none, but in general, don’t expect to pay more than $800 for this portion of the process.
Some lenders will charge a fee to have the loan documents reviewed for accuracy prior to closing. This type of fee can range from $200 to $400.
Some lenders will charge you to cover the fee they pay to the lawyer or organization that reviews and conducts the actual closing. This can sometimes be referred to as, or be lumped in with, an escrow fee. This can cost anywhere from $500 to $1000.
Depending on the institution providing the loan, and where you live, there may be additional fees added into your closing costs. For example, when a home switches hands in the state of California, a seller is legally required to provide the buyer with a natural hazards disclosure report, which may be something your new lender will want to have on file as well. In Florida, tax stamps are required to refinance, and are often over $1000. It’s important to check your state and local laws for various requirements for buying, selling, or refinancing a home. Your lender may also charge you additional fees, like courier costs, underwriting fees, etc.
Any or all of these fees may be included in the total amount of your closing costs. It’s important to assess all of these factors when determining your initial investment, as an accurate estimation is pertinent to determining your actual break-even point.
Some lenders offer a “no-cost” refinance option, where fees associated with closing costs are all waived. This can be very tempting, especially if you’d like to refinance right away but haven’t yet saved up enough money to cover the closing costs. However, it’s best to avoid “no-cost” options, as they almost always come with a higher interest rate. Some lenders even claim to offer the refinancing at no cost to you, but tack all of the fees onto your loan amount, giving you a higher principal to pay off. Also keep in mind that no matter who is offering a no-cost option, there may be state and local fee requirements that cannot be avoided.
Generally, you should only consider a no-cost refinance if you have a severely pressing need for a lower monthly payment, but cannot come up with the closing costs. Also, if you plan to sell or refinance your home again in less than five years, the higher interest rate associated with a no-cost loan may be negated when you re-hash everything.
If you are still considering a no-cost refinance, go about it diligently. Ask your lender for a comparison quote so you can see side-by-side how much each option will end up saving (or costing) you in the end. A higher interest rate over years and years will certainly end up costing you more than the initial closing costs associated with a refinance, and it’s always best to pay the fees in advance if saving money is truly your goal.