- 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 for more real estate
and financial advice, and hit that little bell icon
to get notified every time I upload a new video.
Thanks so much for watching,
and I'll see you over in the next video.