Will a New Loan Really Save You Money?

Refinancing accounts for a major proportion of mortgage applications these days, hovering just under half of all applications for the past few weeks according to the latest Mortgage Bankers Association Weekly Survey.

Before you consider jumping onto the refinance bandwagon, however, you should know whether or not a new loan will really save you money.

Refinancing a mortgage involves closing costs, just like any other mortgage. They typically amount to around 2% to 4% of the loan, and include an origination fee, along with other administration fees covering things like an appraisal and a title search.

Before you refinance, you need to know how long it will take for the savings from the lower monthly payments on your new loan to compensate you for the refinancing costs. Move out of your home before you reach the break-even point, and refinancing wasn't worth it. Move out afterwards, and it was a smart financial decision.

You can calculate how long you would need to stay in your home for refinancing to pay off, with the help of the online Refinance Break-Even Calculator from BankingMyWay.com.

This calculator provides a number of break-even points (in months) based on the different ways to calculate the savings from refinancing.

Monthly Payment: The simplest way to calculate the savings is based on the difference between the monthly payments on your old and new loans. This is a common approach to calculating your break-even point, but it doesn't take into account the additional payments -- including the additional interest -- you will have to make if you refinance with a new loan whose term is longer than the years that remain on your existing loan.

PMI and Interest: This approach to calculating your savings considers just the PMI (private mortgage insurance) and interest portions of your monthly payments, along with refinancing fees. This approach addresses limitations of the Monthly Payment approach by zeroing in on the changes in your monthly interest payments. This calculation tells you how long it will take for the lower rate on your new loan to compensate for the new loan's additional interest payments as well as fees.

Total After Tax: Mortgage interest and PMI payments are tax deductible, so a refinancing that reduces these payments also reduces your potential tax deductions. This approach takes that into account.

Total vs. Prepayment: This method takes into account the opportunity cost that you suffer when you pass up the chance to prepay part of your mortgage with the cash you are instead using to pay your refinancing costs. Such a prepayment would reduce your interest costs over the life of the loan. With this in mind, the total vs. prepayment method tells you how long it will take for the after-tax interest and PMI savings to exceed both the closing costs and any interest savings you would have realized by using those costs to prepay part of your loan.

The calculator requires a fair amount of information about your original loan: the amount you are borrowing, the interest rate on the loan, how many years left on your mortgage, your estimated tax bracket and the purchase price of your home.

PMI is mandatory on loans with less than a 20% down payment, and the calculator determines whether you are paying PMI based on the difference between the purchase price of your home and the amount you borrowed.

You must also enter the interest rate for your new loan, your closing costs and the current appraised value of your home (this is to determine whether or not you are required to pay PMI going forward). The calculator determines the remaining balance on your mortgage based on your original loan information.

Let's say you are considering refinancing a $200,000 30-year fixed-rate mortgage you took out 15 years ago to buy a $250,000 home. The average rate back in June 1993 was 7.42% for that type of loan, according to the Freddie Mac archives. The remaining balance on your original loan is around $150,410, and the average rate on a 15-year fixed-rate mortgage, as of May 29, is 5.66%, again according to Freddie Mac.

Now assume that you'll pay $3,000 in closing costs if you refinance the loan (1% origination fee and about $1,500 in miscellaneous costs). If you're in a 25% tax bracket, your various break-even points range between 14 and 21 months.