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The Hidden Costs of Refinancing

These are the fees and factors to consider when deciding whether to refinance your mortgage.

Refinancing a home sounds easy, right? Just fill out some paperwork and you’ll lower your interest rate by 1% or more.

Not so fast. There are some hidden costs associated with getting a new mortgage — any new mortgage — and if you’re unaware of these costs, you may your heart set on finding a vacation home for sale in Key West, FL and be surprised by the expense of your mortgage refinance.

Getting a loan at a significantly lower interest rate can justify these costs, but heed the following advice — and measure the true impact a mortgage refinance can have on your bank account — to help you decide whether refinancing your mortgage is worthwhile.

1. Mortgage application fee

This is the fee you pay to apply for a new mortgage. (When you refinance, you close out your current mortgage and open a new mortgage.) The application fee tends to hover around $250 to $500.

2. Appraisal report

Most lenders will require a house appraisal to determine whether it has enough value (and you have enough equity) to qualify for the new mortgage loan. This appraisal can cost anywhere from $300 to $600, and the outcome of the appraisal can determine whether it’s smart to refinance. If an appraisal finds that your home value dropped and the ratio of your loan-to-value is higher than your lender allows (typically 80%), you may have to put down cash to make up for it, or buy mortgage insurance.

3. Loan origination fee

The loan origination fee is typically about 1% of the total value of your loan. If you refinance a principal balance of $200,000, for example, your origination fee will be around $2,000. There is a little wiggle room to negotiate in your Good Faith Estimate, a form that gives you a reasonable estimate of the loan terms and the settlement charges.

4. Document preparation fee

Many lenders will charge you a document preparation fee that typically ranges from $200 to $500.

5. Flood certification

You may need to pay $50 to $150 for flood certification, which is mandatory in some areas.

6. Title search

Before your lender approves the refinance, they may require a title search, which can cost $200 to $400.

7. Title insurance

The lender and the homeowner will probably be expected to purchase title insurance to guard against any problems or errors with the title transfer. This may amount to $400 to $800, though rates vary.

8. Recording fee

The county or city you live in may charge a recording fee for handling the paperwork, which may add another $25 to $250 to your total bill. On the whole, expect to pay (as a very rough ballpark) about 1.5% of your principal loan amount in closing costs when you refinance. The bulk of this, about 1%, will be in the form of the loan origination fee, while all the ancillary charges (document prep fee, appraisal, etc.) may add another 0.5% or more to your bill.

But there’s more

Of course, those are the surface costs — the literal fees and expenses that get added to your mortgage bill. Possibly the biggest hidden cost of a mortgage refinance is that your amortization starts from square one.

“Amortization” refers to the way in which your payments get applied toward principal reduction, as opposed to interest payments. It’s tempting to believe that if you have a 5% interest rate, and you make a $105 payment, $100 will go toward your principal reduction and $5 will go toward interest. But that’s not how mortgages work.

Instead, your payments are applied primarily toward interest at the beginning of your mortgage and predominantly toward principal as you reach the end of your payments. In the first year of a 30-year mortgage, your regular payments will barely make a dent in your principal balance; the bulk of your payments will be applied toward your interest. In the 29th year, those trends will be reversed.

Bottom line: Should I refinance?

So should you refinance? You can calculate this two ways:

Crunch preliminary numbers. Find your break-even point by estimating your closing costs on refinancing a loan and comparing them to your estimated monthly savings.

For example, if your principal is $200,000, you can estimate 1.5%, or $3,000, as the closing costs on a mortgage refinance. And if refinancing will lower your payment from $1,200 per month to $1,100 per month, you’ll save $100 per month, or $1,200 per year. In this scenario, you’ll recoup the closing costs in two and a half years. If you know you’ll keep the mortgage for longer than those 2.5 years, you might want to refinance.

Consider the term length and total interest. The real benefit to refinancing is saving money on interest over the life of the loan. The example above assumes that you’re keeping the same mortgage duration (e.g., refinancing from a 30-year into another 30-year). If you change the duration (e.g., refinancing into a 15-year), your monthly payment will rise, even though your interest rate will fall.

It also assumes that you’re close to the start of your existing mortgage. If you’re already 10 years deep into your mortgage and you refinance into a new 30-year mortgage, you’ll end up paying on your house for a total of 40 years. This can potentially cause you to pay more in interest, even if your monthly payments are lower.

The solution? Check your lender statements (or use a mortgage calculator) to see how much interest, in total, you’ll pay on your existing loan.

Then calculate the amount, in total, you’ll pay on a refinanced loan and add it to the interest you’ve already paid on your current loan. Which amount is larger?

Combining the interest payments you’ve already made with your interest liability from a new mortgage allows you to determine whether this new interest number is less than the existing interest due on your current loan. This calculation will necessarily take term length and total interest into account.

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