Lower Your Mortgage Rate
One great reason to refinance your mortgage is to secure a lower mortgage rate, saving yourself money over time. Just ensure that your refinance penalty—which is calculated several ways—doesn’t exceed your potential savings.
Example Savings Through a Refinance
Let’s look at a detailed calculation assuming you have a home valued at $350,000 with an outstanding $250,000 mortgage. You are two years into a five-year term with a fixed rate of 5.0% and are considering a new five-year term at 3.5%. Throughout the example we will examine refinance savings and costs.
To evaluate the interest savings, you start by calculating the difference between mortgage rates. You then apply this to your mortgage balance for the remaining 3 years left in your 5-year term:
The major cost of refinancing is your mortgage breakage penalty, which is supposed to capture the lost revenue to your lender when you terminate your mortgage contract. On a fixed rate mortgage you will pay the greater of three months interest or interest rate differential. On a variable mortgage you will only pay three months’ interest. Since our example involves a fixed mortgage rate, we must determine both 3 months’ interest and the interest rate differential (IRD) and choose the greater.
Now that we have calculated both 3 months interest and the IRD, we see that the IRD is a bigger penalty, which will be used to calculate the refinance savings.
Under this example, refinancing would give us $4,050 in savings.
In some cases you may be responsible for legal fees associated with registering a new mortgage on your property. As a general rule however, if your mortgage loan is between $250,000 – $300,000, your lender or broker will often cover legal fees.
When refinancing to a lower mortgage rate, you should also consider using some of your equity to consolidate debt or finance other projects. As of July 9th, 2012 the maximum loan to value ratio on a refinance is 80%.
For example, on a home worth $350,000, you can have a mortgage of $280,000 (80% * $350,000). Comparing the $280,000 to the existing mortgage balance of $250,000, you can take an additional $30,000. If you do have outstanding credit card debt, an auto loan or a personal line of credit at a higher interest rate, then you can combine all of this debt into your mortgage.