When thinking about refinancing a mortgage, auto loan or other debt, there are several factors to consider that will determine whether it saves or costs you money.
What is Refinancing?
Refinancing is paying off an existing loan with a new loan. To make it worthwhile, this new loan will come with better terms or a lower interest rate that will ultimately save you money in a way that is useful to you. Others opt to refinance as a way to consolidate debts into one loan with one payment, making their debt more manageable to pay off.
Sounds great, right? It’s important to also note that the refinancing process comes with processing/closing costs- often 3-6% of the loan’s principal, appraisals, title searches and a lot of paperwork. So, where’s the breakeven? How do we know when it’s beneficial to refinance?
When Should I Refinance?
In general, the best time to refinance is earlier in your loan term as this is generally when most of the interest on a loan is paid. Say you have a 30-year home mortgage. Did you know that in the first year 83% of what you pay goes towards interest? By year 30, only 3% of your payment goes towards interest. When you refinance, you will start over with most of your monthly payment going towards interest.
Why Should I Refinance?
Lower Your Rate
One of the top reasons people refinance a loan is to secure a lower interest rate than their current one. Historically, experts advised it was beneficial to refinance if your interest rate could be reduced by 2%. These days, experts say even just a 1% rate drop will make refinancing worthwhile. So, if rates have dropped significantly since your loan origination, it may be wise to investigate refinancing.
Shorten Your Term
Another top benefit of refinancing is to decrease your loan term, thus paying less interest over the life of your loan. When interest rates drop, you can also reduce your loan term without much of a change in your overall payment. Consider this example: You have a 30-year fixed-rate mortgage on a $100,000 home and can refinance from 9.0% to 5.5%. If you cut the term in half to 15 years, your monthly payment will only change slightly- from $804.62 to $817.08 but will save you over $140,000 in interest!
If you’ve racked up thousands of dollars in credit card, medical or other debt, it’s possible you can refinance all these balances into one loan and save money. Crunch the numbers. Depending on your current interest rates and new interest rate, it could be beneficial, particularly with the high interest rates often associated with these types of debt. Try our debt consolidated calculator to see if you could save money.
Is it Worth it?
There are two main reasons to refinance: save on your monthly payments or save on the total life of your loan. If your goal is to save over the total life of a loan, a lower interest rate may not do the trick if the term is the same or longer than your current term due to total interest being paid.
Everyone’s financial situation is different, so how do you know for sure if refinancing is going to be the right choice?
Calculate your breakeven point. This is the point where the costs associated with refinancing the loan are equal to the savings. To do this, divide the refinancing closing costs by the monthly savings you would be getting. Example: refinancing is going to cost you $5,000 and will save you $200 a month. $5000/$200=25 months to breakeven. Anything after that would be savings.
If you don’t plan on staying in your home or having your car for longer than the breakeven point, it does not make sense to refinance. You can also use our refinance breakeven calculator to help visualize different scenarios.
When done correctly, refinancing has the power to help you save significantly over the loan, but it isn’t the solution for everyone and every situation. Still not sure if refinancing is right for you? Contact us! We offer free, personalized financial counseling services where we can analyze your specific financial situation and advise on the best ways to achieve success.