When considering refinance, try for a ‘home run’

January 18, 2013

We have a mortgage loan on a second home (it’s a vacation home) with our credit union. The APR is at 4.039 percent, and the loan is just a little over a year old. We have about $63,000 in equity in the home, as it is currently valued at $295,000. The current balance is about $232,000. We have top-tier credit.

Does refinancing at a lower rate make any sense for us?

As we’ve written many times before, refinancing pays off in spades if you can simultaneously lower your monthly payment, lower the interest rate on your loan, lower the payments you make over the life of the loan and keep your refinancing costs at a minimum. We like to call that a “home run” refinance.

We mention all of these objectives because some people look at only their monthly payment as a guide to whether they should refinance. If you focus only on the interest rate, you lose perspective on the amount of interest you pay over the life of the loan.

So, if you refinance your loan now into a new 30-year loan, you’re adding one additional year of interest onto the loan term you currently have. You may lower your interest payment on a monthly basis but increase the amount of interest you pay over the life of the loan.

If you focus only on the interest rate and not on the costs to refinance your loan, you may get a lower rate but not benefit much from that rate if the savings on the new rate don’t compensate you for the costs of refinance for years to come.

Let’s say you are able to lower your interest rate by 0.25 percent, and your monthly payment goes down $32 per month. If your closing costs are $3,200, it will take you about eight and a half years to break even, and you’ve added a whole year of additional interest payments onto your loan. This wouldn’t seem to be a good deal even though your monthly payments have decreased.

You mentioned the annual percentage rate (APR) in your e-mail. That APR rate took into account the interest rate you received when you refinanced a year ago along with all the costs and expenses associated with your loan. The APR wasn’t the interest rate you got when you refinanced, but all the costs put together expressed as a percentage interest rate.

When you get a loan, you’d like the interest rate and the APR to be almost the same, which would indicate you’re paying very few closing costs or that the closing costs are part of the loan amount. Sometimes, if you buy down your interest rate — that is, you pay your lender money (points) upfront in exchange for a lower interest rate — the APR will be quite a bit higher than the interest rate.

Having said all that, if you find that you can lower the interest rate on your loan, lower your monthly payment, lower the amount of interest payments (finance charges) you pay over the life of the loan and limit the closing costs, you should absolutely refinance.

If your credit union can refinance your loan and lower your interest rate down by 0.5 percent or 0.75 percent, and you have around $1,000 in closing costs, you might want to refinance, but only if you plan to keep your second home for at least five or more years. If you lower your monthly payment by $50 or more, it will still take you almost two years to pay off the closing costs, and you will have added an additional year to the life of your loan.

You can go to BankRate.com or our refinance calculator at ThinkGlink.com and plug in your loan amount, the new term of the loan and the new interest rate to get your new monthly payment. You should also calculate your payments over the number of years left on your current loan. If your current loan payment is around $1,127 at 4 percent and the lender offers you a new interest rate at 3.5 percent, your new monthly payment would be about $1,040 over 30 years. If you change the loan term to the 29 years you have left, you’ll find your new monthly payment is $1,062, a bit higher since you’re trying to pay off the loan in the same number of years.

So the most important comparison is between your current monthly payment ($1,127) and the new payment with the lower interest rate over the remainder of your current loan term of 29 years ($1,062), or $65 per month. With this information, you can determine whether closing costs make it worthwhile to refinance. As a rule of thumb, you would want to come out even when you compare the closing costs and the reduction in your new monthly payment over 12 months or so.

Ilyce R. Glink’s latest book is “Buy, Close, Move In! Samuel J. Tamkin is a Chicago-based real estate attorney. If you have questions, you can call Ilyce’s radio show toll-free (800-972-8255) any Sunday from
11 a.m. to 1 p.m. Contact Ilyce and Sam through her Web site, www.thinkglink.com.

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