What Goes Into the Mortgage Refinance Decision?

November 4, 2002, Revised November 30, 2006, October 20, 2010

"What is the best way to measure the costs and gains from refinancing so I can be sure I will come out ahead?"

The method I prefer is to compare all costs of your current mortgage and a new mortgage over a future period. The period should be your best guess as to how long you will have the new mortgage. If the total costs are lower with the new mortgage, you should refinance.

This approach is used in my mortgage refinance calculator 3a, Refinancing One Mortgage to Lower Costs. It shows all the costs over a specified period of an existing and a new mortgage side by side. It also shows the break-even period, which is the minimum length of time the borrower must hold the new mortgage to make the refinancing pay. So even if you are not sure how long you will have the mortgage, if you are confident that you will have it longer than the break-even period, you know the refinance pays.

Using a Mortgage Refinance Calculator

I will illustrate with the case of Jane who had a $320,000 loan balance at 6.25% with 300 months to go. Her potential new loan was at 5.25% for 30 years, with cash payments of 2 points (2% of the loan balance, or $6400) plus $2200 for other settlement costs. She guessed she would keep the new mortgage 5 years.

The calculator divided her costs into three groups:

*Upfront costs consisting of points and settlement costs, were $8600 on the new loan, zero on the old one.

*Monthly payments of principal and interest were $106,024 on the new loan and $126,657 on the old one. (These numbers    are calculated by multiplying the monthly payments by 60).

*Lost interest was $7057 on the new loan, $7216 on the old one.

The last item is the interest Jane would have earned on upfront and monthly payments if she had saved those monies at 2.24%, her after-tax savings rate. Loan officers sometimes claim that borrowers don’t understand lost interest. My experience is that most borrowers do understand that money they spend could have earned interest if they hadn’t spent it. Lost interest, however, can easily be excluded from the analysis by setting the savings rate to zero.

The calculator factors in two cost offsets:

*Tax savings on interest and points was $23,469 on the new loan, $25,753 on the old one. Jane’s tax rate of 25.5% was used in this calculation.

*Reduction in loan balance was $25,122 on the new loan, $31,198 on the old one. In both cases, these were measured from the original balance of $320,000.

Deducting the cost offsets from the costs, Jane’s new mortgage had a net cost of $73,089 as compared to $76,922 for the old one. Refinancing would thus save her $3833 over the 5 years. The calculator also indicated that her break-even period was 39 months.

The fact that this refinancing made Jane better off doesn’t mean it was the best. For example, Jane could have replaced the 30-year 5.25% loan with one for 15 years at 5%. Assuming everything else the same, this shift to a 15-year would increase the net gain from refinancing from $3833 to $6098, while reducing the break-even period from 39 to 35 months.

Financing the Refinance Costs

Many borrowers who refinance today finance the upfront costs. That is, they add the costs to the mortgage rather than pay them in cash. Calculator 3a offers a financing option.

Those who try the option find that it reduces the gains from refinancing. This is largely because the borrower must pay interest on the costs at the mortgage rate. If Jane had financed the upfront costs of her new 30-year loan, the net gain from the refinance would have dropped from $3833 to $1240, while the break-even period would have increased from 39 to 53 months.

Financing the costs, furthermore, can flip the loan amount above 80% of property value, which triggers mortgage insurance. If the borrower is already paying mortgage insurance, it can raise the premium. If this had happened with Jane’s 30-year loan, the small gain from refinancing would have become a loss. Fortunately, she had enough equity to avoid mortgage insurance altogether. The calculator automatically factors mortgage insurance into the cost calculation, if it arises.

A side benefit from using a calculator is that it forces borrowers to collect all the information that affects the profitability of a refinance. Once all the relevant information is at hand, it is clear that no two cases are exactly alike. Fortunately, the calculator will handle them all.

Other Reasons  to Refinance

The analysis above assumes that the borrower is refinancing one mortgage in order to lower her financing cost. If there are two mortgages, the process is a little more involved, see Refinancing and Second Mortgages. Furthermore, there are other reasons to refinance. One is to raise cash, see Cash-Out Mortgage Refinancing or Home Equity Loan? Another is to reduce the risk of rate increases by switching from an adjustable-rate to a fixed-rate mortgage, see Is Now the Time to Refinance an ARM Into a FRM?

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