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Ready to Refinance Your Mortgage?

How to determine if refinancing your mortgage will pay off

Sept. 1, 2016

By JACK GUTTENTAG The Mortgage Professor (Tribune News Service)

If you took out a mortgage with a 7.5 percent interest rate in 1994 and still have it, refinancing in a 3.5 percent market is a no-brainer; you don't need much analysis to know that refinancing into today's rates will pay.

The only possible reason a borrower would still hold such a mortgage is a marked deterioration in his credit, the value of his home or in his mental capacity.

If you took out a 5.5 percent mortgage in 2004, the case for refinancing is not as strong but, barring deterioration of the types mentioned above, it is strong enough to move with confidence.

The challenging case is when your mortgage is at 4 percent and was taken out in 2014. This is a situation where the rate reduction might or might not be large enough to offset the costs of the refinance.

This article will explain the valid approach to answering that question and critique an invalid approach used all too often by loan officers.

Factors That Affect the Profitability of a Refinance
A refinance pays if the sum of all the costs arising from the refinance during the period you expect to have the mortgage is less than the sum of the costs of the old mortgage over the same period.

Costs on only the new loan include points and other origination charges paid at closing. Costs on both the new and existing mortgage include monthly payments of principal and interest, mortgage insurance premiums if any, and lost interest on upfront and monthly costs. In both cases, tax savings and the reduction in loan balance must be deducted from total costs.

Don't Be Led Astray by a Spurious 'Break-Even Period'
Another approach to whether or not you will save on a refinance is to calculate a break-even period -- the period over which costs of the old loan and the new loan are equal.

The larger the spread between the new interest rate and the rate on your existing loan, and the smaller the cost of the new loan, the shorter the break-even period.

If you are confident that you will have the new mortgage longer than the break-even period, you will benefit from the refinance.

But beware!

The break-even period is not the cost of the new loan divided by the reduction in the monthly mortgage payment.

Many loan officers use this rule of thumb, which completely ignores how rapidly you pay off the new loan as opposed to the old one.

Borrowers following this rule would never refinance into a shorter term loan because of the increase in payment, although the total benefit including the pay-down of the loan balance is substantially greater on refinancing into a 15-year loan, as indicated above.

The rule of thumb does not work for any borrower who is concerned with how long they have to pay, which should be every borrower.

Combining the Refinance Analysis With Mortgage Shopping
The answers generated by refinance calculators are no better than the current mortgage prices the user must enter to make the calculators work.

About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

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Copyright (c) 2016, The Mortgage Professor

Distributed by Tribune News Service.

This story was distributed by TNS - Tribune News Service
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