How to Think About Refinancing

Everyone tells me that this blog has become perhaps a mite gloomy over the past few days . . . weeks . . . months.  So let's look at one of the rare bright spots in this financial Twilight of the Gods:  mortgage rates.  They're really low.  So low that my husband and I, who bought our house last October, have been seriously considering refinancing.  I thought it might be worthwhile looking at how we made the decision.

Our mortgage is currently at 4.5%.  But our credit union is offering rates as low as 3.875% on a 30-year fixed, and 3% on a 15-year fixed.  Since ceteris paribus, I would like to give my bank less money, this is tempting.

However, those rates aren't free.  They require hefty buy down:  2.75 points plus a 1% origination fee to get to the 3.875% for a 30 year; 2.65 points plus a 1% origination fee to get to the 3% for a fifteen year.  When you add in the other expected costs of closing--title insurance, recordation fees, and so forth--we're talking about thousands and thousands of dollars, plus roughly $2000 in closing costs, and another thousand or so in bank fees.

So how to tell if this is a good deal?

With a simple refinance calculator, like this one from Bankrate.  It lets you see how the refinance will change your monthly payment, and your total interest paid, and how many months it would take you to recoup the costs.  

That calculator told me that the best deal I could get from my credit union was paying 2.75 points (1% origination fee, plus a 1.75 point buydown of my rate) to get a 4% interest rate.  That would pay off in just over 97 months, or 8 years.  This is far too long: what if we moved during that time? What if inflation took off and rapidly eroded the value of my loan?  The Chicago MBA in me would surely regret having used expensive current dollars, rather than cheap future dollars, to pay it down.

How much time you're willing to spend recouping the value of a refinance depends on your life situation: how quickly are you planning to move?  How much do you need the cash right now?  But I think four years is the outside.  Anything longer than that, and there's too much risk that something will change, and you'll end up losing money.

A 15 year was more intriguing.  To be sure, it would raise our monthly payment by over a third.  On the other hand, we'd save over $100,000 in interest payments over the life of the loan, and be living in a paid-off house by 2026.

But switching mortgage terms confused the Bankrate calculator; because our payment actually went up, rather than down, it started estimating a negative payoff time.  So we needed to be a little more creative.

The answer I found was using another calculator from Bankrate: its amortization table.  I started by plugging in the information on my current mortgage, and noting the total interest paid, along with the monthly payment.  Then I plugged in the details for the 3% fixed mortgage.

Wow, what a change: by going to a 15 year at a lower interest rate, we'd save a lot of money.  I won't go into our personal details, but someone with a $250,000 mortgage who switched between our rate, and a 3% 15-year, would pay about $460 more a month in payments--but would pay just $60,000 in interest over the life of the loan, compared to over $200,000 with a 30-year.

But there is the matter of that higher payment. Our mortgage payment is about 20% of our take home now, so we can swing a higher payment with some comfort.  But what if one of us got sick?  What if some other currently unforseeable calamity befell us?  A lower mortgage payment provides a nice cushion.

One way to think about it is this: the 30 year mortgage represents option value.  We pay extra on our mortgage each month right now, but having a thirty year gives us the option not to, if we hit a rough patch.  How much are we paying for that option?

To find out, I started playing with the "extra payment" feature.  How much extra a month would we have to pay on our current mortgage, in order to replicate the paydown date of a 15-year at 3%?

The difference turned out to be substantial.  For that $250,000 mortgage we discussed, the answer is "about $650"--or $200 a month more than you'd pay if you just took the 15 year.  Over the life of the loan, you'd pay about $30,000 more in interest.

That's an expensive option--it's almost half of the difference in payment between the 15 year and the 30 year.  If someone had offered to sell me the option to pay $450 less on my mortgage whenever I felt like it, would I be willing to pay $200 for the privilege?

God no!  And yet, we hesitate.  There's also the cost of refinancing to consider.  On our hypothetical $250,000 mortgage, it would cost us about $12,000 to buy our rate down to 3%.  What if we took that $12,000 right now and paid down the mortgage with it?  Suddenly it would only take $550 a month to pay off the mortgage in 15 years.  The mortgage insurance suddenly looks a lot cheaper.

And that's before you consider the tax deduction.  It gets smaller a lot faster with the 15-year; about a third of the extra interest cost is actually mitigated by the mortgage interest tax deduction.  So the true cost on a $250,000 mortgage would be more like $18,000 in extra interest payments over 15 years--or $1200 a year.  Which begins to seem like a non-insane amount to ensure that your personal finances stay in the black.

We're still puzzling over the decision.  But there's one thing to note: the reason that we're struggling with it is that we already have a fabulously low mortgage rate.  While I was writing this post, I started an IM with a friend in New York.  It turns out that his mortgage is at 5.875%, but he hasn't refinanced yet, because his mortgage company wants him to pay points.

If you haven't refinanced since 2005, don't be afraid to pay points!  Or find a lender who doesn't ask for them.  Either way, you'll probably get your money back in less than a year.  In general, as long as you aren't underwater, if your mortgage interest rate is currently over 5%, it probably makes sense for you to refinance--even if you're planning to move in a couple of years, as my friend is.

Just make sure you run the numbers first.