Lower Interest Rates Do Not Mean it is Time to Refinance

Interest rates drop and homeowners with mortgages run out to get in on the action. A lower interest rate isn't always better. Yes, it may seem to save you money each month on your monthly mortgage payment, but there is more to consider than the interest rate alone to see your true savings.

Closing costs and fees
Even when you receive those attention grabbing postcards in the mail that promise a low interest rate of 4.875 percent and no closing costs, there are fees involved. If something seems too good to be true, it is. There are always fees associated with a mortgage transaction, so it's not about asking what the closing costs are. You want to ask what your total fees, charges and closing costs are for the transaction.

For example, my parents bought a new home in December 2008 using a VA loan. At least twice a week, they receive a postcard or letter in the mail from a VA mortgage lender telling them how low their interest rates are (usually in the 4 percent area), how they can skip two mortgage payments and pay nothing in closing costs.

I was there yesterday and saw one of these postcards. I was intrigued so I picked up the phone and called. With my dad's perfect credit score and veteran status, he can get an interest rate a little over 4 percent and he can skip two mortgage payments when he refinances. The savings per month works out to be approximately $331. It doesn't cost him anything out of pocket because they'll roll the $16,000 in costs right into the loan amount. I'm sure they will.

Yes, you saw that right. Their no closing cost option turned out to be $16,000. They didn't call them closing costs per se. They called them a VA fee, one point, one discount point, and miscellaneous title search and recording fees, but any way you spin it, it's $16,000.

Time in the home
It's not about the interest rate alone and it's not about the costs and fees alone. You also need to consider how long you expect to be in the home. If you expect to live in or own the home for less than four years, it is usually not beneficial to refinance because typically you won't recoup the costs and fees of refinancing to break even.


Break-even analysis
Your final decision should be made using a break-even analysis. This calculation allows you to consider your savings per month if you refinance and the costs and fees associated with the refinance. You can determine how long it will take you to recoup your costs or break even. If you plan on being in the home the same amount of time or longer than it takes you to break even, then it may be worth the cost of refinancing.

Break even = Fixed Costs / Variable Cost

In a mortgage situation, the fixed costs are the fees, charges and closing costs associated with refinancing. The variable cost is your monthly savings on your mortgage payment. When determining your monthly savings, make sure you are comparing apples to apples. If you currently pay principal, interest, taxes and insurance (PITI), make sure that the new payment also includes PITI.

In the example with my parents, the fixed costs are $16,000 and the variable cost is $331.

Break even = $16,000/331 = 48.33 months/12 = 4.02 years

Since they do not plan on being in the home for the next four years, it isn't worth it to them to "pay" $16,000 to save $331 per month, even though their interest rate would be almost two points lower than their current rate.

Before you refinance
Before you refinance, be sure to get all of the facts and do the math. It isn't always about getting a lower interest rate. It's also about the costs involved and the amount of time you plan on being in the home. Conduct your own break-even analysis and make sure you are making a decision to refinance for the right reasons.