- So if you own a home, at some point, you've probably received
a letter in the mail that looks something like this. A random online lender claimed that they can save you $100, $200, $500 a month on your mortgage payment by refinancing with them. But the truth is, most of these letters
are practically scams. And today, I wanted to
break that down for you and explain why that is. I also want to go over when
it actually does make sense for you to refinance your home, and I'm gonna share with
you a simple formula that you can use on your own home to determine if you actually
would save any money by refinancing at a lower interest rate. So before we dive into this, I want to lay a foundational understanding of how your mortgage
payment actually works. So every month, your mortgage payment that you make to the bank
is actually comprised of at least four smaller payments. They call this PITI, P-I-T-I. So the P in PITI stands for principle. So this is a portion of
your mortgage payment that is going straight to paying
down your debt to the bank, so how much you still owe the bank. The I in PITI stands for the interest. So this is the interest that you're paying on the remaining balance
that you owe to the bank. And since your balance
that you owe to the bank is getting paid off a little bit with every mortgage payment, the interest that you're
paying on the remaining balance is also reduced a little bit with each mortgage payment. Now, the T in PITI stands
for your property taxes, and the I stands for your
homeowners insurance. You see, your bank doesn't want the state to repossess your home because you didn't pay
your property taxes, and they also want to make sure that your house has
homeowners insurance on it, since your house is the
collateral for your mortgage. So they include that in
your mortgage payment, and then they make those
two payments for you. Now, when you first start making payments on a 30-year mortgage, a lot of your first few
payments is gonna go towards the interest on
the remaining balance, and only a little bit is gonna go actually towards paying
down the principle. But since every single
mortgage payment that you make, your principle balance is
lowered just a little bit, that means that the
interest that you're paying on each subsequent mortgage payment is also going down just a little bit more. But if you have a fixed
rate mortgage payment and you add up how much of that payment is going towards interest and how much is going towards principle, the sum of those two
numbers is always the same for every single payment, but what changes is the ratio of how much is going towards principle and how much is going towards interest. So if you were to actually
graph out your mortgage payment, this means that at the
start of your 30-year loan, a lot of your mortgage payment is going to go towards the interest, and it's gonna slowly come down, and then quickly, faster and faster, start making a lot more progress. So it's gonna have a gradual decline, and then pretty quickly curve down in those later years of your mortgage. And now at the same time, how much of your payment
is going towards principle does the exact same thing,
but in the other direction. So it's gonna have a slow,
gradual upward motion, and then quickly curve upwards as more of your mortgage payment is going towards paying
down the principle. And as you can see, you really want to get
into the later years of your 30-year mortgage, where more of your mortgage payment is going towards paying
down the principle. And you want to get out
of these earlier years as soon as you can. But what's funny is that
the banks and your lenders actually want you to stay
in these earlier years here, where more of your mortgage payment is going towards the interest and less of it is actually
going towards the principle. So let's look at some real numbers here. And let's say in 2010, you bought a home and you took out a loan for
$300,000 at 4% interest. When you add up the principle and interest on all of your mortgage payments, it's gonna come out to $1,432 a month. And on your very first mortgage payment, that breaks down to $1,000
going towards the interest and $432 going towards the principle, paying down your debt to the bank. Now, if you fast forward to today, and you're now 10 years
into your 30-year mortgage, instead of $1,000 of each mortgage payment going towards the interest, which is the profit that the banks make, now, only $787 of each mortgage payment is going towards the bank. And now, instead of $432 of
each of your mortgage payments going to pay down your debt, you now have $644 going
to paying down your debt. And instead of owing the bank $300,000 like you did at the start of the loan, now, you only owe the bank $235,000, 10 years into the loan. And now, let's say at this point, you get a letter in the mail saying that if you refinance your mortgage, they can save you $300 a month. And let's just say it's at
the exact same interest of 4%. So let's look at what would happen if you actually move forward at this. So, first off, instead of you paying your mortgage off 20 years from now, now, you're starting a
brand new 30-year mortgage on your remaining balance of $235,000, and you're not gonna
finish paying that off for at least 30 years. But if we look at it a
little bit more closely, we see that when you're 10
years into a 30-year mortgage, $644 of every one of those payments was going towards paying
down your principle and building you equity in your home. And I look at paying down the principle and building equity in your home sort of like you're putting
money into a savings account which you can't touch
until you sell your home. So you're essentially
saving for the future by paying down your principle. But now, if you're starting
a brand new 30-year mortgage, the amount of your mortgage payment that is going towards
your principle goes down from 644 down to 339. And this is where that $300
savings is really coming from that your mortgage
lender is promising you. So it's not really saving you any money, just instead of you building
$300 in equity in your home, you instead you get to keep that money in your checking account. But it actually gets worse than that, because your new lender is gonna be charging you closing costs for the privilege of
refinancing your home. And they most likely will just be adding these closing costs to the balance that you
owe on your mortgage. So your closing costs include things like an application fee,
a loan origination fee, a settlement fee, a title search fee, an appraisal fee, a credit
report fee, et cetera. And generally, these add up to about two to 6% of the loan amount. So the national average closing cost for refinancing a mortgage is $5,779, and this typically just gets added back to the balance that you owe the bank. Now, oftentimes, your lender may require or highly encourage you to
buy points on your mortgage, and this is a onetime upfront fee that actually lowers your
interest rate on your mortgage. And points may cost you
a few hundred dollars, all the way up to a few thousand dollars, and they also just get added
to the principle balance that you owe the bank. Now, despite the fact that buying points will lower your monthly
mortgage payment slightly, for the vast majority of the
time, they are not worth it, and you're gonna end
up spending more money in the long run by buying
points on your mortgage. You see, the lender's
gonna highly encourage you to buy points on your
loan when you refinance because they make more money by selling you points on your mortgage. And the reason why points are not worth it for the the vast majority of people is 'cause most people
either sell their house or refinance their mortgage long before they actually see any savings from buying points. To determine if points are
actually worth it for you, you need to do what's known
as a break even analysis. So as an example, let's
say your lender says for $4,000 upfront, you can buy one point, and that's gonna reduce your
monthly mortgage payment by $57 a month. And so that means it would
take you 70 mortgage payments, or almost six years, to recoup your initial
investment of $4,000, and before you actually
start saving any real money. So if you know ahead of time that you are gonna live in that home for longer than six years, let's say that you're retiring and you don't plan on
refinancing your mortgage within those six years, then yes, this actually could save
you money in the long run. But if you're like most people, you don't know if you are gonna be living in the same house six years from now, or maybe you plan on having a
larger family in the future, then buying points most
likely is not worth it, because you're either gonna sell your home or refinance that mortgage long before you see any savings
from buying the points. And unfortunately, there are
a lot of people out there that refinance their
mortgages every few years, or do a cash out refinance, and they do pay for the points every time to get that
lower interest rate, and they never make any real progress on paying down their debt to the bank. In fact, there's a lot of people that all they're doing is increasing
their debt to the bank every time that they refinance. So in the first example I gave you, I showed how refinancing your mortgage at the same interest rate in order to lower your
monthly mortgage payment really doesn't make any sense, and I also showed you
how paying for points when you refinance, for most people, also doesn't make any sense. But we are seeing historically
low interest rates right now, so you're probably asking yourself, "What about refinancing "to lock in a much lower interest rate?" And yeah, sometimes it does make sense to refinance to lock in
a lower interest rate if you're gonna live
in the home long enough to take advantage of that. So to determine if it's worth it for you to refinance to lock
in a lower interest rate, we're really gonna need
three different numbers for you to do your break even analysis, and the first number is gonna be what your current balance
is on your mortgage. So you can log into your bank account or look at your most recent statement to figure out what this is. In our example, when we were 10 years into a 30-year mortgage, our current balance was $235,000. So the second number you
need to figure out is how much interest you're paying on your current balance a year right now, and then determine how much interest you're gonna pay a year
with your new interest rate. And the difference
between these two numbers is gonna be about how much you save every single year in interest. So with our example, we owe $235,000. If we multiply that by 4% to get how much we pay
in interest every year, we see that we're paying about $9,428 a year in interest on that balance. So let's say you refinance and
you get half a percent lower, so you got 3 1/2% interest
rate instead of 4%. You would only be paying
$8,249 a year in interest. And the difference
between those two numbers is $1,179 a year that you're gonna save by refinancing into that lower interest rate. So the third number
that you need to know is what are the closing costs
to refinance your mortgage? So how much is it gonna cost you to get this lower interest rate? And you can get a free estimate
for refinancing your home pretty much from any lender out there. Now, when you get your estimate, make sure that they're not
charging you any points. A lot of lenders will
automatically charge you points and not fully explain how they work. And feel free to shop around, maybe get multiple estimates
from a few different lenders. But let's use the
national average of $5,779 in closing costs to
refinance your mortgage. So now, you need to determine
how long you need to live in that home before the
savings that you get every year is greater than that upfront cost to refinance your mortgage. So we divide that $5,779 in closing costs by your annual savings of $1,179, and we get 4.9. So in this scenario, it would
take you about five years to save more money than
you were initially spending to refinance your mortgage. But let's say instead of lowering your interest rate only half a percent, you actually got a full percentage lower, and you went from a 4%
mortgage down to a 3% mortgage. So at 3% interest rate with this scenario, you'd pay $7,071 a year in interest. And if you compare that to how much you're paying a year at a 4% interest, you're saving $2,357 a year in interest, and that's actually pretty good. So once again, if we divide
your closing costs of $5,779 by your annual savings
of $2,357, we get 2.5, so two and a half years
before your savings is greater than how much it costs you to refinance your mortgage. So if you plan on living in that home for longer than 2 1/2 years, and you're not expecting
to refinance again within that time period, then it would make sense for you to refinance your mortgage
at that lower interest rate. Now, if we go back to
the original example, I talked about how one
of the major pitfalls of refinancing into a new 30-year mortgage is that you don't really
make much progress on paying down your debt. So if you do refinance your mortgage to lock in a lower interest rate, this is something that you want
to take into consideration, and you may not want to go
for another 30-year mortgage. If you were 10 years
into a 30-year mortgage, you may just want to finance
into a new 20-year mortgage. And that way, the amount of money that's going towards your principle is gonna stay about the same every month. And if you actually wanted to
pay your principle off early and put that savings that
you're making every single month towards the principle, you could instead refinance
into a 15-year mortgage, or even a 10 year-mortgage. And banks actually offer
you lower interest rates for these lower time periods, because there's less risk to the bank. So now that you understand
a little bit more about how your mortgage payment works, if you want to learn 10 hacks to pay your mortgage off early, check out this video I did right here, breaking those down for you. Don't forget to subscribe
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