Calculating the net benefit of refinancing can be a challenging task if you do not understand what to calculate. We are going to focus on the net benefits of refinancing from the standpoint of lowering your interest rate.
Although there are several reasons to refinance, lowering your mortgage rate to save on interest payments over the term of the loan is the most popular.
Calculating the actual savings can be a tricky chore unless you know the difference between cash flow savings and interest savings. If your refinance objective is to only save on the interest by lowering your rate, then the interest savings should be done with the calculations below.
Calculating Interest Savings:
(Loan Amount x Interest Rate) / Months in year = Interest paid per month
($200,000 x 6% or .06) / 12 = $1,000.00
*Remember to do the calculation in the parentheses first*
We now know that you are paying $1,000.00 per month in interest. You should take the new interest rate you are getting with your refinance and calculate what your new interest payment will be.
($200,000 x 5% or .05) / 12 = $833.34
Now we need to find out the difference between the two interest rates.
Current Interest Payment – Proposed Interest Payment = Interest Savings
$1,000.00 – $833.34 = $166.66
Now you have figured out that by dropping your interest rate 1% on $200,000 you will be saving $166.66 per month or about $2,000 per year.
Anyone would want to save $2,000 per year, where do I sign… right? Not so fast, you’ll want to calculate the break-even point to find out how you will benefit after your closing costs.
Net Benefit Formula (Break-Even):
(Closing Costs – Escrows) / Interest Savings = Month of Break-Even
($6,000 – $1,000) / $166.66 = 30 Months
In other words, it will take 30 months for you to recoup the cost of your refinance. If you plan to keep your mortgage for at least 30 months then you might want to consider this deal.
Okay, now we can calculate your net benefit for refinancing with one more calculation.
(Monthly Savings * Months you plan to keep mortgage) – (Closing Costs –Escrows) = Net Savings
($166.66 * 120 months) – ($6,000 – $1,000) = $14,999.20
If you kept the mortgage for 120 months (10 years) you would save $15,000.
Okay, now you can find out where to sign.
Calculating the net benefits of a refinance is crucial in determining if it is strategic for you to refinance. Keep in mind that each mortgage is slightly different and you may need to adjust calculations accordingly.
Frequently Asked Questions:
Q: I heard that I should only refinance if I drop 1% on my mortgage is that true?
Some people say ½% , 1% to never. Every mortgage is different.
For Example: A no cost loan can have a 1 month break-even point with only a .25% drop in interest rate. Now that you know how to calculate your net benefit, you are able to figure out what may be best for your situation.
Q: Why can’t I just compare my current payment to the proposed payment and figure out my net benefit?
You could just compare just the two payments if you wanted to find out your cash flow savings, but the current and proposed loans may have two different amortizations.
Let’s assume you currently have a 15 year mortgage and you’re comparing it to a 30 year mortgage. If both loans have the same interest rate and loan amount but the amortization is different, your interest savings per month would be $0. However, you are going to show a cash flow savings with the 30 year mortgage because of the longer amortization.
Related Article – Refinance Process:
- Refinance Process Overview
- Mortgage Approval Process
- Four Possible Reasons To Refinance
- Should I Refinance Or Get A Home Equity Loan To Make Improvements?
- What Do Appraisers Look For When Determining A Property’s Value?
- Understanding The Difference Between Appraised Value vs Neighborhood Listing Comps
- Five Myths About Home Values