Cash-out mortgage refinance - when does it really pay?

With the enticing low interest rates and appealing offers, homeowners mortgage refinance seems to be a current trend. It is tempting to jump on the bandwagon and do the same. While mortgage refinance is a wise choice in many situations, it is important to note that it is not cost-free.

As we mentioned in Cash-out mortgage refinancing or home equity loan - which is better for you?, first mortgage rates traditionally are the lowest rates around. Banks and loan investors feel the most secure with these loans because they have first-lien position (ie first-priority claim) against the property in the event the borrower defaults on the loan.

Therefore the benefits of first mortgages, or of cash-out mortgage refinances used to replace (ie refinance) first mortgages, are the relatively lower interest rates.

The disadvantages of first mortgages are the closing costs, also known as settlement costs, that the borrower must pay the lender at the time of closing, in addition to the down payment. These closing costs may include application fees, loan origination fees, and others.

You may remember that you paid the closing costs when you took out your first mortgage. When you take out a new loan such as a cash-out mortgage refinance to refinance your current mortgage, you must pay these closing costs all over again.

Since it costs you money out of your pocket to do a mortgage refinance, how do you know whether or not your new mortgage will save you money?

To answer this question, you have to do a cost-benefit analysis. The costs are the closing costs (or settlement costs). The benefits are the interest savings. If the cumulative interest savings exceed the total closing costs, then the mortgage refinance is worthwhile. But in order to determine your cumulative interest savings, you must know how long you will keep your house for. If you sell your house a few years after you do the mortgage refinance, you may not have accumulated sufficient interest savings to offset the closing costs.

How do you work out the cumulative interest savings? Use an online mortgage calculator or refinance calculator. Look for their sources on this site.

The larger the interest savings, ie the larger the difference between the new refinance mortgage rate and the rate on your existing first mortgage, the sooner you can recover your closing costs, ie the shorter the breakeven period. The breakeven period is the time taken for your cumulative interest savings to be approximately equal to the total closing costs.

Please note that the breakeven period is not the cost of the new mortgage refinance divided by the reduction in the monthly mortgage repayment. This is the rule of thumb widely used to simplify the explanation of the breakeven period. It may be simple, but it's wrong.