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Do the math before refinancing your mortgage

John Perry is an assistant professor of economics at Centre College in Danville.
John Perry is an assistant professor of economics at Centre College in Danville.

Question: With mortgage rates so low now, my husband and I are thinking about refinancing our home. However, I've been told it's not always in your best interest to refinance. What's the best way to determine if we should do it? We've got 20 years left on our loan with 6.25 percent interest and principal remaining of around $250,000.

Answer: It is an excellent time to consider refinancing. In general, a refinance is a good idea if the savings are greater than the cost. The rub is that a refinance has a significant upfront cost in the closing costs while the savings happen over time.

Getting an estimate of closing costs is easy; lenders are required to provide it. Figuring the savings is a bit trickier because you save money only as long as you have the home.

A back-of-the-envelope approach to this problem is to compare how many months it will take you to recoup the closing costs with how long you plan to stay in the home.

First, find your monthly savings by subtracting the principal and interest payment of the refinance mortgage from your current principal and interest mortgage payment. Then divide the closing costs by the monthly savings. This gives you the number of months it will take you to break even on the refinance.

Given your information, I estimate your current principal and interest payment is about $1,825 a month. A new 20-year mortgage with an interest rate of 4.5 percent would have a principal and interest payment of about $1,580. You can get estimates of current market principal and interest payments online at the Lexington Mortgage Guide on Kentucky.com. That means you will save about $245 a month ($1,825 - $1,580 = $245).

If closing costs are $3,000, it would take you about 13 months to break even on the refinance, as $3,000 divided by $245 is just less than 13. Starting in the 14th month, the refinance saves you money.

If you plan to be in the house a while, you should run to get refinanced. In doing so, I strongly encourage you to shop lenders for the best rate and closing costs. I also advise your refinance mortgage term be no longer than the length of time you have left on your current mortgage.

Q: Most American consumers spend the most on automobiles as a physical asset, second only to a house. We hear an awful lot about buying new versus old, buying or leasing, trade-in to dealer versus selling on a market, etc. However, we hear very little about how long to keep a new or used car after the initial purchase.

I have heard the conventional wisdom about keeping a car until the repair cost exceeds 50 percent of the "Blue Book value" — this seems quite simplistic. What depreciation rules should factor into decisions on the length of time to hold an automobile? I have most often bought new and held the car at least 10 years, and one up to 18 years.

A: Let me suggest another approach: Compare the repair cost to the benefit to you of the car running again. The repair cost is easy to measure. Measuring the benefit is not so easy.

One convenient way to think about the benefit is in terms of a prevented expenditure. If repairing the car keeps you from having to spend money on another vehicle, the repair has "prevented" an expenditure.

As an example, pretend you own a vehicle worth $3,000 that needs a $1,600 repair that is expected to give your vehicle six more months of life. Without the repair, you would have bought another vehicle and probably made payments for those six months. Assuming a payment of $400 a month, you would have spent $2,400. The repair costs you $1,600 but prevents you from spending $2,400. That is a good trade.

The uncertainty is how much time a repair will give you. That is where the professional judgment of your mechanic and history of the car should be considered carefully. If breakdowns are becoming frequent, then the benefit of fixing the vehicle shrinks and it might be time to look for another vehicle.

Note that the market value of the vehicle was not critical to whether you should make the repair. The only relevant information to whether the repair should be made is how the cost compares to benefit of the repair.

Q: What's the best software to help me manage my money?

A: There are many players in the personal finance software market. Banks and credit unions are even getting into the arena by upgrading their online banking experiences to be much more than just a place to check balances and pay bills.

That said, the stand-alone personal finance tool that is probably getting the most buzz and one I have been impressed with is Mint.com. It is a free online tool that pulls information from all your financial accounts — checking, savings, mutual funds, credit cards, loans, etc., into one place, making it easy to track your entire financial life.

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