Here are the steps required for this type of analysis:

1. Get information on loans currently available. This includes the interest rate, number of points, and term.

2. Find out the current balance on your loan. You may ask the lender for this information.

3. Find out if you have to pay a prepayment penalty on your current loan. If so, calculate how much the penalty will be.

4. Add up the costs of refinancing. This includes the prepayment penalty, the application fee for the new loan, and all closing costs on the new loan. Ask the lender you have chosen for an estimate of these closing costs. This estimate need not be precise but should be a good approximation of the costs.

5. Calculate the payments on the new loan. You can do this using a table or find out from the lender.

6. Calculate the after tax payments of both your current loan and new loan. You may just multiply the monthly principal and interest payment (subtract out the escrow) by one minus your marginal tax rate (see Key 24). This is close enough for this analysis. Now subtract the new payment from the old payment to find the monthly savings.

7. Compare the savings to the costs to find the amount of time before you break even. This can be done several ways:

a. Payback method. Simply divide the costs by the savings. This gives you the number of months to recover your investment.

b. Discount method. The payback method assumes that money in the future is worth as much as money now (see Key 23). A more realistic method uses a discount rate. This is the interest rate you could earn on money you invest. Estimate the rate (what can you earn from a bank CD) and the money you could earn each month. Use the monthly savings as the payment and the costs as the loan amount and find the term of the loan. This is your break even period.

If you finance all closing costs into the loan, you can simply look at the monthly savings. Since the refinancing does not involve a cash outlay, this savings is your return for refinancing.

Here’s an example. The current loan has an interest rate of 14%, a balance of $98,837, and 26 years left to run. The monthly payment is $1184.87. There is a pre­payment penalty of 2% of the balance ($1977). The new loan is at 10% for 30 years and requires one discount point. To refinance the outstanding balance of the old loan, the payments will be $867.37.

The borrower’s marginal tax rate is 28%, so that the after-tax cost of the old loan is $853 (1185 times 1 minus .28) and new loan is $625. The savings is $228 per month. Costs of refinancing are as follows:

Prepayment - $1977
Points - 988
Application - 300
Appraisal, survey, other - 500

Total costs - $3765

With the payback method, it will take 16.5 months to recover the costs ($3765 divided by $228). At a discount rate of 6%, it will take 17.3 months to recover. Therefore, if the borrower plans to stay in the home at least two more years, it pays to refinance the loan. If the clos­ing costs are financed into the loan, the new loan will be $102,602 (the balance of the old loan plus the closing costs). The monthly payment will be $900.41, giving a monthly savings of $205 per month after taxes. Although the principal balance is increased and the mortgage term is lengthened, the monthly payment savings in two years more than offsets the costs.

Only principal and interest payments are relevant for these calculations. Taxes and insurance will be the same no matter how the property is financed.