Most Lenders Don't Want You To Know This Refinance Tip

This key number can negate refinancing.

Whether you need the extra money for bills, home improvement, or your child’s college education or you simply want a lower interest rate, refinancing your mortgage is an option homeowners can consider.

Most homeowners, however, don’t look at one of the most important factors when deciding if refinancing is the right choice for them. This factor is the Payback Period.

What is the Payback Period?

Payback Period is an economics term that refers to the amount of time it takes an investor to recoup his or her original investment. For example, if you gave a friend $1,000 to start a business, the payback period would be the amount of time it took for your friend to return that $1,000 to you.

In terms of mortgage refinancing, the Payback Period is how long it takes for the monthly savings on the refinancing to equal or exceed the closing costs of the new loan.

Calculating the Payback Period

While you can use a refinance calculator to figure out the exact payback period for your situation, let’s look at a hypothetical example to illustrate how those calculations are determined.

Let’s say you refinance your home and end up saving roughly $300 per month because of the reduced interest rate and the lower principal (by the time you refinance you should have already paid a chunk of your home’s cost). The closing costs associated with that loan are $3,500. The question is – based on these numbers – how long the payback period would be.

To find the answer, you simply divide the closing costs by the monthly savings. In this case, that would be $3,500 divided by $300. The result would be just over 11.6 months, so the payback period for this mortgage would be almost one full year.

Why Does the Payback Period Matter?

Knowing the payback period, whether you do the calculations by hand or use a refinance calculator, can help you determine whether refinancing is the best choice at this time. Let’s come back to the example we used above.

If you are planning to put the house on the market in six months, then you’ll be selling the house before you’ve been able to recoup your investment through the savings. That would be an unwise investment decision.

On the other hand, if you have no plans to sell within the next year, you would accumulate enough monthly savings to make the investment in the refinancing worth the cost.

Other Factors to Consider

Using a refinance calculator can help you determine the payback period, but there are other factors you want to consider as well. For example, if you refinance a home you’ve been paying on for five years then you need to consider if the extra savings will also be enough to cover the additional five years of interest you will be paying on the loan.

If you took out the original loan in 2008, the loan should have been paid in full by 2038. If you refinance after 5 years, you won’t pay the mortgage off until 2043. Those extra years could add on enough interest to outweigh your initial monthly savings.

Related blog