Saving Money by Refinancing Your Mortgage

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 one 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.



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

Now I'm intentionally using an old table, and rates are higher now. I'm 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 by default. 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

Now, 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 principle 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. On the other hand, I have a solid history of going five years between refinancing, so it makes a certain amount of sense, 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. 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!). 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. So long as you don't trigger the 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 a minimum payment since the first time I refinanced!



Now some 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.



Caveat Emptor.