Mortgage lending is big business, and with lower interest rates right now, it’s bigger than ever. If you’re already paying a mortgage, no doubt you’ve seen or heard countless ads telling you it’s time to refinance. But is it? Let’s take a look at some of the factors you should consider before saving your paystubs and gathering your bank statements. Even with lower interest rates, refinancing isn’t a good idea for everyone.
Bill and Helen’s Story
Bill Reed and his wife, Helen, are 29-year-olds who bought their home about two-and-a-half years ago. As first-time homebuyers without a large down-payment, the Reeds were able to lock in a 30-year fixed rate mortgage at 4.375% and monthly mortgage insurance of $145.90 per month. Their monthly house payment, including the mortgage insurance, came to $2204.92 – a pretty large sum. But Bill and Helen felt owning a home was a good investment.
The couple’s monthly payment consisted of $450.11 toward their principal, $1,123.89 toward interest, plus the mortgage insurance, which they needed to pay for 91 more months. With 342 more monthly payments, the couple would eventually pay a total of $540,192.14, of which $231,926.14 would be interest.
Then their lender, John, called with what seemed like a fantastic deal.
“If you would like to refinance, we can lock in a new, lower interest rate of 3.75% and lower your monthly payments,” John said. He explained that with the new interest rate, the Reeds’ monthly payments over 27 years would be $2,130 – about $74.92 less each month. Under the new arrangement, monthly mortgage insurance payments would be $69, about $76.90 less, and would last for 77 months instead of 91. Over the life of the loan, John told the Reeds they could expect to make 324 house payments totaling $510,932.43, of which $189,932.43 would be interest.
Bill told John to send over the paperwork, and that he and Helen would discuss it. The Reeds were excited about the possibility of saving that much money over time, but Helen thought they should discuss terms with their financial adviser, just in case they were missing something. She set up an appointment for the next day.
At their appointment, Bill showed Bob, their adviser, the interest rate disclosure sheet that John had sent over. It showed the new interest rate of 3.75%, and the total loan amount of $321,000.
In talking with the Reeds, Bob knew they were thinking of starting a family. He also knew they could eventually outgrow their home over time.
“How long do you think you’ll be in your home?” Bob asked Bill. Bill and Helen looked at each other for a moment. “Five years, maybe? If we can save some money while we’re in it, why wouldn’t we take advantage of it?” Bill asked.
“Let’s see if this is really a bargain,” said Bob, pulling up his calculator. “Did you notice the discount fee of 2.75% on the loan?” he asked. “That’s the amount of money you’re paying the lender in exchange for a lower mortgage interest rate. They’re also called ‘points,’ and each point is equivalent to 1% of the value of your home.”
Bill looked at the interest rate disclosure form again. “When it said ‘discount,’ I thought maybe that meant money being discounted from the price of the loan. So, what you’re saying is, we’re paying $8,827.50 up front to lower our interest rate over the life of the loan?” he asked.
“Yes,” said Bob, “even though it says ‘discount,’ that’s not exactly what it means. You are actually paying this amount now so you don’t pay it in interest over time. Let’s figure out how long you need to stay in your home to recoup the cost of buying these points. There’s a simple formula,” he added, drawing it on a sheet of paper. You take the cost of the points – in this case, $8,827.50, and divide it by your monthly payment savings. The result is equal to the number of months it will take for you to break even.
“Based on my calculation, it will take you just under 10 years to break even with this loan arrangement,” said Bob, and that doesn’t take into account that amount you’ll also pay for an appraisal, loan origination fees, title search, document preparation fees, inspection fees, and any other costs required as part of the loan. Instead of saving money, it looks like you might be spending quite a bit more, considering you’ll only be in your house for five more years.”
Helen’s eyes grew wide. “You’re kidding!” she exclaimed. “John led us to believe we’d be saving much more money by refinancing. You’re saying it could cost us thousands more?”
Bob sighed. “Yes, unfortunately,” he said. “Loan origination costs can be between 1 and 1.5% of the total principal you owe, and the other fees could add up to more than $1,000, so your all-in costs could be around $10,000 or more. If you’re looking to save money, refinancing in this situation just doesn’t make sense.”
When Should You Refinance?
Admittedly, the example of Bill and Helen’s situation is simplified. Many factors, including taxes and insurance, can add to monthly payments as well. My point is that there’s no “one size fits all” approach, even as TV and radio ads tell you it’s a great time to refinance.
While refinancing didn’t make sense for Bill and Helen, there are some instances when it could make sense. For example, if your goal is to pay off your house, you may consider refinancing from a 30-year mortgage to a 15-year note. Your monthly payments will increase, but more of that amount will be principal, and in 15 years, you will own your home free and clear. In another example, if you have an old adjustable rate mortgage (ARM), it may be wise to convert to a conventional loan now that rates are low.
I’ve seen a number of “rules of thumb” about refinancing, but whether you should follow them depends on your situation. Some experts believe that if interests rates fall more than 1%, or if you expect to stay in your house for more than 10 years, refinancing may be a good idea. But talking your situation through with your adviser first may be the best course of action. If we can be of assistance, please feel free to contact us.