"Should I Refinance?" - Consider Overall Cost of Money, Not Payment

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With the state of financial education in this country, many people shop for loans by payment, figuring the lowest payment is the best loan. As counter-evidence to that idea, let us consider the negative amortization loan. I've seen them with minimum payments computed based upon a nominal rate of zero point five percent on forty year amortization. This gives a minimum payment of $1150 for a $500,000 loan - but the actual rate on that loan is eight point two percent, meaning if you were just going to pay the interest, that would be $3417 per month. If you made that $1150 minimum payment, you'd owe over $2200 more next month - and you'd be paying interest on that added principal as well. By comparison, principal and interest on a six percent thirty year fixed rate jumbo loan is only $2998 - and there's no prepayment penalty either.

Don't get distracted by payment. Look at the real cost of the money - what you're paying now in interest, versus what any new loan will cost, plus what you'll be paying in interest on it. You do have to be able to make the payment, but once that's covered, look at the real cost of any new loan, both in up-front costs and in interest paid per month. Those are the important numbers.

Let's suppose you were one of those folks who had to settle for a subprime loan a couple of years ago. You had something bad happen, but now you're past it. You've been diligent and careful with your credit these last couple years, so you're now able to qualify "A paper". On the other hand, your current loan has now adjusted to nine percent, and your prepayment penalty has expired, while there are now thirty year fixed rate loans in the sub- five percent range. When I originally wrote this I could have moved you or anyone else able to qualify A paper into a thirty year fixed rate loan at about 6% for literally zero cost, meaning there is no possible (financial) reason not to do such refinance. (These days, thanks to Congress trying to "protect" consumers, zero cost loans are gone)

The only real question in such a situation is this: "Is it worth the extra money it takes to get a better rate?", because there is always a tradeoff between rate and cost. For instance, to look at the differences for someone who currently has a $300,000 loan, when I originally wrote this two of the choices were six percent for zero cost or five point five for about half a point. Both are thirty year fixed rate loans.

The six percent loan has a balance of $300,000, same as your old balance, and payments of $1798.65. The five point five percent loan carries an initial balance of $304,325, and payments of $1727.90. Lest you not understand, that 5.5% loan cost you $4325 to get done, as opposed to literally zero for the six percent loan. This isn't a matter of "keep searching for the provider who gives you the lower rate for the same cost", as this tradeoff is built into the entire financial structure. Some providers may have higher or lower tradeoffs, but the concept of the tradeoff isn't changing for anything less than a complete and radical rebuild of the financial markets. Not. Gonna. Happen. You can find different costs for the same rate, but the difference between a low cost provider and a high cost provider usually isn't going to be more than a point

However, for spending that money all in a lump sum, you get a lowered cost of interest. You save $105.19 that first month in interest, and this number actually increases slowly for the first few years of the loan. In month 21, you've theoretically broken even, even though your loan balance is still almost $3600 higher, you've gotten the extra money you've paid to get the lower rate back. However, because you still owe $3600 more, if you refinance at this point, you're still going to end up behind as that $3600 you still owe translates to $216 per year at 6%, assuming that's the interest rate on your next loan. Maybe you sold the property and bought something else, maybe you refinanced for cash out. In either case. you owe $3600 more than you would have, which means you're paying interest on it when you get your next loan. But something like thirty percent of all borrowers have sold or refinanced by this point, and when they do, those benefits you paid for stop. Nor do you get any of the money you paid in the first place back.

It isn't until you've kept the loan 124 months - over ten years into the loan - before you are unambiguously better off with the lower rate but more expensive loan. That's how long it takes until the balances are even on the two loans. Of course, by then you have saved about $13,000 in interest - if you actually keep the loan that long. Less than one borrower in 200 does.

Real break-even is likely to be somewhere in year four in this case. After three years, you've saved about $3800 in interest, and if your balance is still that almost much higher with the expensive loan than the cheap one, we're getting to the point where time value of money will keep things in favor of the more expensive upfront costs. Of course, last time I checked Statistical Abstract, decidedly less than half of all borrowers kept their new loans this long. Something to think about, because you don't get the money you spent to get the loan in the first place back. By the end of year four, assuming we keep the loan that long, we've saved $5000 in interest, while the balance is only $2600 higher for the 5.5% loan than for the 6% loan. Even without time value of money and with a ten percent assumed rate of return, that's additional twenty years before the costs of the higher balance catches up with the benefits you've already gotten through lower interest. Considering time value of money, it's really never going to catch up.

So when you're looking at refinancing, don't just consider rate and payment. Consider what it's going to cost you in order to get that new loan, and remember what the costs are of doing nothing (i.e. you've already paid the upfront costs of doing nothing). Many people refinance every two years, spending much more than $3400 every time they do, because they'll spend two or three points to get the lowest rate. This, as you can see now, is a recipe for disaster.

Caveat Emptor

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About this Entry

This page contains a single entry by Dan Melson published on April 28, 2014 7:00 AM.

What Drives Loan Rates? was the previous entry in this blog.

In Order To Deal With Looming Foreclosure, You Must Get Out of Denial is the next entry in this blog.

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