Saving Money by Refinancing Your Mortgage

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pfadvice talks about debunking a money myth and perpetuates one of his own. He took issue with someone refinancing to lower their monthly payment, insisting instead that the term of the loan was all important.

His point is understandable in that because folks tend to buy more house than they can really afford, they also tend to obsess about that monthly payment. The solution to this is simple to describe but it takes someone with more savvy and willpower than most to bring it off: don't buy more house than you can afford.

Actually, there is nothing that is all important, but if I had to pick thing as most important, it would be the tradeoff between interest rate and cost and type of loan. This is always a tradeoff. They're not going to give you a thirty year fixed rate loan a full percent below par for the same price as loan that's adjustable on monthly basis right from the get-go.

This tradeoff varies from lender to lender and also varies over time. Nor is it the same for borrowers with different credit, equity, or income situations, but it is always there. For a given borrower at a given time, any program which you can qualify for will have the rate/cost tradeoff built in. If you want them to pay your closing costs, you're going to have to accept a higher rate than if you're willing to pay two points. It is the relationship between whatever loan you have now, and the loans that are available to you, that determines whether it's a good idea to refinance. Focus on the real cost of the money: The interest rate, which determines what the cost of borrowing the money will really be, and the total upfront cost to get that loan, which breaks down into points and closing costs.

If you have a long history of keeping every mortgage loan you take out five years, ten years, or longer, then perhaps it might make sense for you to take out a thirty year fixed rate loan and pay some points. To illustrate, I'm going to pull a table out of an old article of mine because I'm too lazy to do a new one.



rate
5.625
5.750
5.875
6.000
6.125
6.250
6.375
6.500
6.625
6.750
6.875
7.000
discount/rebate
1.750
1.250
0.625
0.250
-0.250
-0.750
-1.250
-1.500
-2.000
-2.250
-2.500
-3.250
cost
$4725.00
$3375.00
$1687.50
$675.00
-$675.00
-$2025.00
-$3375.00
-$4050.00
-$5400.00
-$6075.00
-$6750.00
-$8775.00


I'm intentionally using an old table, and rates are different now. The point is to examine your current loan in light of what's available to you now, and determine whether there's a loan that's worth the cost of doing. Maybe your equity situation has improved. Maybe your creditworthiness has improved. It's possible that something has deteriorated, and the loans that are available also vary over time with the state of the economy. If you've got a prepayment penalty that hasn't expired, remember to add the cost of getting out of that loan to the cost of your refinance, because it certainly changes the computations by adding a large previously sunk cost to the cost of your new loan. Whatever it is, the loans available to you now will be the total result of all of how all of the factors in the situation have changed.

I'm going to keep the example simple, assuming no prepayment penalties, and the third column is cost of discount points (if positive) or how much money you would have gotten in rebate (if negative), assuming the $270,000 loan I usually use. Add this to normal closing costs of about $3400 to arrive at the cost of your loan, thus:

(I had to break this table into two parts to get it to display correctly)



Rate
5.625
5.75
5.875
6
6.125
6.25
6.375
6.5
6.625
6.75
6.875
7
Points/Rebate
$4,725.00
$3,375.00
$1,687.50
$675.00
($675.00)
($2,025.00)
($3,375.00)
($4,050.00)
($5,400.00)
($6,075.00)
($6,750.00)
($8,775.00)
Total cost
$8,125.00
$6,775.00
$5,087.50
$4,075.00
$2,725.00
$1,375.00
$25.00
($650.00)
($2,000.00)
($2,675.00)
($3,350.00)
($5,375.00)
New Balance
$278,125.00
$276,775.00
$275,087.50
$274,075.00
$272,725.00
$271,375.00
$270,025.00
$270,000.00
$270,000.00
$270,000.00
$270,000.00
$270,000.00
Payment
$1,601.04
$1,615.18
$1,627.25
$1,643.22
$1,657.11
$1,670.90
$1,684.60
$1,706.58
$1,728.84
$1,751.21
$1,773.71
$1,796.32



rate
5.625
5.750
5.875
6.000
6.125
6.250
6.375
6.500
6.625
6.750
6.875
7.000
New Balance
$278,125.00
$276,775.00
$275,087.50
$274,075.00
$272,725.00
$271,375.00
$270,025.00
$270,000.00
$270,000.00
$270,000.00
$270,000.00
$270,000.00
Interest*
$1,303.71
$1,326.21
$1,346.78
$1,370.38
$1,392.03
$1,413.41
$1,434.51
$1,462.50
$1,490.63
$1,518.75
$1,546.88
$1,575.00
$saved/month
$130.80
$108.29
$87.73
$64.13
$42.47
$21.10
$0.00
($27.99)
($56.12)
($84.24)
($112.37)
($140.49)
break even
62.11922112
62.5610196
57.99355825
63.54001705
64.15695892
65.17713862
0
0
0
0
0
0


In the next tables, I've modified the results based upon some real world considerations. Point of fact, it's rare to actually get the rebate (typically, the loan provider will pocket anything above what pays your costs), and so I've zeroed out those costs. You take a higher rate, you're just out the extra monthly interest. The fourth column is your new balance, the fifth is your monthly payment. For the second table, I've duplicated rate and new balance for the first two columns, the third is your first month's interest charge (note that this will decrease in subsequent months), the fourth is how much you save per month by having this rate, and the fifth and final column is how long in months it will take you to recover your closing cost via your interest savings as opposed to the cost of the 6.375% loan, which cost a grand total of $25 (actually, this number will be slightly high, as interest savings will increase slowly, as lower rate loans pay more principal in early years).

However, let's look at it as if your current interest rate is 7 percent. Your monthly cost of interest is $1575, there, so let's see how long it takes to actually come out ahead with these various loans.



Rate
5.625
5.75
5.875
6
6.125
6.25
6.375
6.5
6.625
6.75
6.875
7
Loan Cost
$8,125.00
$6,775.00
$5,087.50
$4,075.00
$2,725.00
$1,375.00
$25.00
$0.00
$0.00
$0.00
$0.00
$0.00
New Loan
$278,125.00
$276,775.00
$275,087.50
$274,075.00
$272,725.00
$271,375.00
$270,025.00
$270,000.00
$270,000.00
$270,000.00
$270,000.00
$270,000.00
Saved/month
$271.29
$248.79
$228.22
$204.63
$182.97
$161.59
$140.49
$112.50
$84.38
$56.25
$28.13
$0.00
Breakeven
29.94960403
27.23218959
22.29233587
19.9144777
14.89346561
8.50926672
0.177945838
0
0
0
0
0

In short, since you're recovering costs quickly, it would make sense for folks with a rate of 7 percent to refinance in this situation, no matter how long they have left on their loan. For $25, they can move their interest rate down to 6.375, saving them $140 plus change per month. It's very hard to make an argument that that's not worthwhile. On the other hand, I would have been somewhat leery of choosing the 5.625% loan, as more than fifty percent of everyone has refinanced or sold within two years. However, if I have a solid history of going five years between refinancing, it makes a certain amount of sense, at least considered in a vacuum. Considered in light of the real world, rates fluctuate up and down. So I tend to believe that if I don't pay very much for my rate, I'm likely to encounter a situation within a few years where I can move to a lower rate for zero, or almost zero, whereas if I paid the $8125 for the 5.625%, rates would really have to fall a lot before I can improve my situation.

Do not make the mistake of thinking that the remaining term of the loan is more important than it is. You now have (assuming you took the 6.375% loan) $140 more per month in your pocket. Your payment will go down by more than that, but you're actually saving $140 per month in interest. It's up to you how you want to spend it. If you want to spend it paying down your loan more quickly, you can do that (providing you don't trigger a prepayment penalty, of course - but the loans I quoted didn't have one). Let's say you were two years into your previous loan. Your monthly payment was $1835.00. If you keep making that payment, you'll be done in 288 months; 48 months or 4 full years earlier than you would have been done under the original loan. So long as you don't trigger a prepayment penalty, you can always pay your loan down faster. Just write the check for the extra dollars and tell the lender that it's extra principal you're paying. I haven't made just the minimum payment since the first time I refinanced.

Many folks focus in on the minimum payment. By doing this, you make the lenders very happy, and likely your credit card companies as well. Not to mention that you are meat on the table for every unethical loan provider out there. It is critical to have a payment that you can afford to make every month, and make on time. But once you have that detail taken care of, look at your interest charges and how long you're likely to keep the loan, not the minimum payment or the term of the loan.

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About this Entry

This page contains a single entry by Dan Melson published on December 8, 2013 7:00 AM.

Inducements to Use A Builder's Lender for a Purchase was the previous entry in this blog.

Low Equity (or Worse!) Relocations in a Buyer's Market is the next entry in this blog.

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