When is it Right to Refinance?

With "everyone" talking about the historically low mortgage rates you are ready to decide if it "pays" to refinance. The "rule of thumb" supplied by mortgage companies is that if you can reduce your interest rate by 1% it is usually profitable.

But there is more to it than that. Like how long are you planning on staying in the house? If there were no fees or costs involved that wouldn't be a consideration.

But in the real world, the first thing you need to determine is what rates do you qualify for and what are the other factors like points and closing costs . 

When you refinance it is common to roll the additional costs and fees back into the mortgage so there are no "out of pocket" costs. But this allows the Bank or other mortgage holder to charge you interest on these fees. At the current low interest rates and if you choose a short time period for your mortgage the additional interest will be relatively small.

But even at these low rates, if you have a 30 year mortgage, interest will end up doubling the amount of fees over the 30 year life of the loan. 

Case Study: 

Let's assume you took a 30 year, $115,000 First mortgage on a house 5 years ago. The interest rate at the time was 7.5% and your principal and interest payment was $765.10 per month.

(If $765.10 sounds low to you, remember your "actual payment" may also include mortgage insurance, taxes and home owners insurance.)

After paying $765.10 per month or $9181.20/year for 5 years you have spent a total of $45,906. Plus, you still owe about $108,000 on your $115,000 mortgage and you still have 25 more years to go! 

Obviously, not much of your payment goes toward principal the first few years of a 30 year mortgage! So the sooner you can get out from under the better.

Now that interest rates have fallen to around 5% you are considering refinancing. Let's assume Closing Costs and additional fees and expenses will be about $3,000. This means you will have to "borrow" $111,000. to pay off your $108,000. loan (or come up with the $3,000.) from savings.

If you decide to refinance the additional costs for another 30 years... your loan amount would be $111,000. and you would be almost back to where you started 5 years ago... but your payment would drop to $595.87 for a monthly savings of $169.23

Now although it would be nice to have an additional $169.23 to spend each month, the question is what will you do with the money? Go out to eat more, buy more toys? Invest it in your retirement fund? Or just "spend it"?

If you just "spend it"... it isn't really helping you get ahead and you are now in debt to the bank for an additional 5 years. Not a good prospect...

So what if we set the mortgage term to 25 years so at least we aren't moving backwards. In that case, your payment would be $648.89 saving you $116.21 per month. So for an additional $53.02 per month you knocked 5 years off your mortgage! 

Personally, we think that is a slightly better solution. At least you aren't pushing your retirement out an additional 5 years while you continue paying your mortgage.

Remember, the original question was... Is it worth it to refinance and pay the additional $3000. or just keep paying on the existing mortgage?

Keep in mind, as soon as you sign the papers the equity you have in your house drops by $3000! Assuming you chose the 25 year mortgage (with the $116.21/mo savings) it will take you 25.8 months to break even ($3000/$116.21) because at that point you will have saved the $3000. it cost you to refinance. Any time in the house after that is gravy.

So if you intend to stay in your house 3 or more years it would pay for you to refinance.

But wait what if you took it one step further? What if you kept your payment the same as you are paying now and reduced the term of your mortgage as far as possible? A $111,000 mortgage at 5% with a payment of about $765 would require a term of 223 months or about 18.5 years. 

Assuming you could get an 18.5 year mortgage and you intended to stay in your house that long, this would be an excellent move! You have drastically reduced the amount of money you will pay the bank over the life of the mortgage and you are free and clear 6.5 years earlier!

Even if you have to move sooner, your equity will be building faster so you will be able to take more money with you when you sell.

Unfortunately, lenders do not usually let you choose an odd term length like 18.5 years , so you would have to choose either a 20 year term with a payment of $732.55 which would still save you about $30/month but also knock 5 years off your loan (and build equity somewhat faster).

Or you could choose a 15 year term with a payment of $877.78 which would actually cost you about $110/month more than what you are currently paying but would knock a full 10 years off your mortgage. If your income has risen since you got your initial mortgage and you could swing it... it would be money well spent. 

For those with higher incomes who have difficulty saving, this is a great idea because

it actually forces you to save a little bit more each month and once you get used to it, you won't even miss the money. 

Another idea is to see if you can remove the mortgage insurance off your mortgage. On this loan, the mortgage insurance might add an additional $100/month to the loan (for the first 10 years), so you would still have to pay it for 5 more years.

But...

if you have made improvements or renovation to the house... or property values have increased dramatically in your neighborhood... you might be able to get the new loan without the mortgage insurance. If you can, you will save an additional $100/month! With that savings you can move to the 15 year mortgage without mortgage insurance for the same amount that you are currently paying for a 30 year mortgage with mortgage insurance. Not bad eh? Whack 15 years off your mortgage just like that!

Another way to reduce the monthly payment is to...reduce the amount you borrow. If you could come up with the additional $3000 in closing costs from savings, your monthly payment on a 15 year mortgage would drop from $877.78 to $854.06 ... or only about $89. per month more than what you are currently paying.

Is it worth $89/month to knock another 5 years off your mortgage?

That depends on your personal circumstances! If your budget is already stretched to the limit, or it will put you at risk if you lose your job, NO.

But if you can find a way to come up with $3.00 per day (perhaps by giving up cigarettes, or skipping a trip to the vending machine or to McDonalds) it will save you thousands over the life of your mortgage!
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