Refinancing often seems like a great way to reduce your monthly mortgage payments and leave you with more money for other things. However, when you’re weighing the pros and cons of a refinance, don’t forget to consider how this move can affect your net worth.

Key Takeaways

  • A simple payback period method is often used to calculate the month when a homeowner’s cumulative savings are greater than the cost of a refinance.
  • A more financially sound way to calculate the cost of refinancing is to consider the impact on your household’s net worth.
  • To find out when a refinancing decision becomes economical, homeowners must compare their existing mortgage’s remaining amortization schedule to the amortization schedule of the new mortgage.

Why? A mortgage is more than a monthly payment. It is a debt instrument used to finance an asset. And that accounting-professor jargon means that having a mortgage lowers your net worth.

Here’s how the reasoning works. On a household’s balance sheet, a mortgage is a liability. As such, it is subtracted from the household’s assets to determine its net worth. Too many consumers fall into the trap of refinancing a mortgage in order to lower their monthly payments without considering how that refinancing affects their total net worth. Does refinancing your home ever pay off? Or is it just a short-term fix to a bigger problem?

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The Payback Period Method

The most popular method for determining the economics of mortgage refinancing involves calculating a simple payback period. This equation is made by calculating the sum of the monthly payment savings that can be realized by refinancing into a new mortgage at a lower interest rate and determining the month in which that cumulative sum of monthly payment savings is greater than the costs of refinancing.

Suppose, for example, you have a 30-year mortgage loan for $200,000. When you took it out, you got a 6.5% fixed interest rate, and your beginning-of-the-month payment is $1,264. If fixed interest rates now are at 5.5%, this could reduce your monthly payment to $1,136, making for a monthly savings of $128, which is $1,536 annually. The typical rule of thumb is that if you can reduce your current interest rate by 0.75% to 1% or higher, it could make sense to consider refinancing.

Next, you’ll need to ask your new lender to calculate your total closing costs for the possible refinance. For example, if they come to $2,300, your payback period would be 1.5 years in the home ($2,300 divided by $1,524). Thus, if you plan on staying in the home for two years or longer, refinancing makes sense, at least according to the simple payback period method.

What the Payback Period Method Misses

However, this method ignores the household’s balance sheet and the total net worth equation. Two primary things are unaccounted for.

Cost of Refinancing

With the simple payback period method, the principal balance of the existing mortgage versus the new mortgage is ignored. However, refinancing is not free. The costs of refinancing must be paid out of pocket or, in most cases, rolled into the new mortgage’s principal balance.

When a mortgage balance increases through a refinance transaction, the liability side of the household balance sheet increases, and, all other things being constant, the household net worth immediately decreases by an amount equal to the cost of refinancing.

Total Mortgage Interest Paid

Just because you are getting a lower interest rate on your refinanced mortgage doesn’t mean that you will pay less in total interest on it. For example, refinancing a 30-year mortgage with 25 years left until it is paid off into a new 30-year mortgage means that you might end up paying more total interest over the life of the new mortgage. It all depends on how much lower the new interest rate is.

The Household Net Worth Method

A more financially sound way to determine the economics of refinancing that incorporates the actual costs into the household net worth equation is to compare the remaining amortization schedule of the existing mortgage against the amortization schedule of the new mortgage.

The amortization schedule of the new mortgage will include the costs of refinancing in the principal balance. If the costs of refinancing will be paid out of pocket, then for a proper comparison the same dollar amount should be subtracted from the existing mortgage’s principal balance. This is based on the assumption that if the refinance transaction does not take place, the money you would shell out for costs could instead be used to pay down the principal balance of the existing loan.

Subtract the monthly payment savings between the two mortgages from the new mortgage’s principal balance. This is done because, in theory, you could use the monthly savings generated from refinancing to reduce the principal balance of the new mortgage. The month in which the modified principal balance of the new mortgage is less than the principal balance of the existing mortgage is the month in which a genuinely economical refinancing payback period, one based on household net worth, has been reached.

By the way, amortization calculators can be found on most mortgage-related websites. You can copy and paste the results into a spreadsheet program, then perform the additional calculation of subtracting the monthly payment differences from the new mortgage’s principal balance.

An Example of the Household Net Worth Method

Using the above-described calculations, a refinance analysis of an existing mortgage with a fixed interest rate of 7%, 25 years remaining until repayment, and a principal balance of $200,000 into a new 30-year mortgage with a fixed interest rate of 6.25% and refinancing costs of $3,000 (which will be rolled into the new mortgage’s principal balance) gives the following results:

If a simple payback period analysis is used to determine the economics of refinancing in the above example, the cumulative monthly payment savings are greater than the $3,000 costs to refinance beginning in month 19. In other words, the simple payback period method tells us that if the homeowner expects to have the new mortgage for 19 or more months, refinancing makes sense.

However, if the net worth approach is used, the refinancing decision would not become economical until month 29, when the principal balance of the new mortgage minus the cumulative monthly payment savings is less than the principal balance of the existing mortgage. The net worth approach tells us that it takes 10 months longer than the simple payback period approach before the refinancing is economical.

If you refinance after your home has lost value and have to carry private mortgage insurance, the negative impact on your net worth could be even more substantial.

Special Considerations

Keep in mind that during periods when home values decline, many homes are appraised for much less than they were previously worth. This may cause you to not have enough equity in your home to satisfy the 20% down payment on the new mortgage, requiring you to come up with a larger cash deposit than expected. It could also require you to carry private mortgage insurance (PMI), which will ultimately increase your monthly payment. In these instances, even with the drop in interest rates, your real savings may not amount to much.

The Bottom Line

By calculating the actual economics of refinancing your mortgage, you can accurately determine the payback period with which you have to contend. Crunching the numbers takes a bit of work, but anyone can do it.

Especially if you are planning on moving in the next few years, taking a few minutes to calculate the actual economics of refinancing your mortgage may very well help you avoid damaging your net worth by thousands of dollars. And if it does look like refinancing will pay off, you will have a much clearer understanding of exactly when you will start benefiting from this move.