To Refi or Not To Refi

Some of the most frequently asked questions that I receive have to do with making the decision to refinance a
mortgage:

Should I do it?
How much will I save?
How do I know if the fees are too expensive?
How much lower does the new rate have to be to make it worthwhile?
How does the new mortgage compare to my current mortgage?
How long must I stay in the new mortgage before I start saving money?

But before we go any further, I must emphasize that it would take hours to discuss every detail needed to address all possible situations and mortgage-refinance options. I will cover many specifics in this presentation, however I cannot cover everything. What will be covered is going to be enough for you to make
solid, well-informed decisions about refinancing mortgages. This presentation will discuss the right ways, and wrong ways, to compare mortgage options. That said, let’s get started with the main question, “Should you do it?”

You should always be thinking about refinancing because your mortgage is probably the most expensive purchase you’ll ever make. Notice that I didn’t say your house was the most expensive purchase. That’s because when you took a mortgage, you purchased that money to pay for the house. The purchase of that
money is paid by the interest charges.

You may have paid $150,000 for the house, but you purchased that $150,000 from a bank for let’s say, 7% APR over 30 years with monthly payments of near $1,000 per month, costing you a total of $360,000.00. That’s $150,000 for the house and $210,000 for the money to buy the house!

Deciding to refinance your mortgage depends, in my opinion, on one main reason, and that is, to save money! It doesn’t make any sense to refinance to a more expensive mortgage. Therefore, the main approach to making
the decision to refinance is going to be figuring out if you’re going to save money.

Much of the difficulty in comparing mortgage options stems from banks twisting the numbers in ways that may confuse you to believe you’re saving money when it’s really costing you more!

To begin the process of comparing your options you need to have options to compare. This means doing a little research to:

1) Contact a few lenders to find out the rates and fees available. You can start by checking your local
newspaper or visit online lenders for quotes.
2) Make a list of all your loan options by rates, fees, and loan type (30-year, 15-year, etc.)
3) Get all the information about your current mortgage so you can compare this against your new loan options. All you need to know is how much you owe, the interest rate, and your monthly payment, not including taxes and fees, of course.

In this presentation, I’m going to address how to compare fixed-rate mortgages only. It’s more involved to compare variable rate mortgages, but rest assured that the same basic principles you learn here, do apply.

Now...the best way to approach this topic is to create a typical, real-life example and then see how to deal with that situation. By using a hypothetical case, we will be able to examine the details and learn exactly how to best handle the numbers when comparing loan options.

For my example, I’ll use Jack’s situation. Jack owns a house that is worth about $200,000. He currently has a 30-year mortgage with 20 years remaining and a balance of $110,000. It’s a fixed rate mortgage with a 6% APR and payments of $788.08 per month, not including property tax, PMI, or any other charges.

From that information, we can calculate that the original purchase price was $131,445, but we don’t need to know that original price. We only need to know Jack’s current payment, interest rate, and outstanding balance. I told you Jack’s estimated home value for completeness, because it does need to be greater than the amount owed or else Jack probably won’t be able to get the loan.

I know that’s a lot of numbers to remember, but don’t worry about memorizing them, because I will refer back to them as we need to.

After doing some research, Jack found a few mortgages that he’s interested in comparing to his current loan:

1) 30-year, 5.75% fixed, no-point mortgage with $600 in total closing costs
2) 30-year, 5.25% fixed, 2-point mortgage with no closing costs.
3) 15-year, 5.375% fixed no-point mortgage with $600 in total closing costs. And finally...
4) 15-year, 4.875% fixed, 2-point mortgage with no closing costs.

When talking about “points” in regard to a mortgage, if you don’t already know, they are the up-front fees that are collected by the bank at closing. Each point is equal to one percent of the loan principal.

Total closing costs include application fees, legal fees, appraisals, and anything involved in acquiring the new mortgage.

It’s important to keep in mind that there are so many numbers here that it can be easy to get confused. Also, there are right ways, and wrong ways to compare loans.

To effectively analyze these loans, I’m going to employ the use of my DebtSmart Loan Calculator. Links to get the calculator are included on this page.

Of course, you can use any accurate financial calculator. However, it is difficult to find good ones—but that’s a different story. Oh, and I should mention that if you stick around for this entire video, I’ll provide you with a free tool that will help you do everything—so keep watching!

First, I’d like to talk a little about how to use the DebtSmart Loan Calculator before we start analyzing Jack’s mortgage options. Note: Video clip explaining how to use the software is here. You must watch the main presentation (cable/dial-up) to see this clip.

Now let’s see how Jack makes a mistake in comparing mortgages. Jack calculates a monthly payment of $641.94 for loan option #1, using the DebtSmart Loan Calculator. That’s a $110,000 balance for 30-years at 5.75%.

Jack’s mistake is that he believes he’s saving $146 per month over his current monthly payment.

Well, that is certainly not the case. Jack’s approach is the wrong way to compare that loan and here’s why:

1) Jack didn’t include the closing costs in the calculations. That loan cost an additional $600 and he did
not use that number anywhere.
2) Jack didn’t take into consideration that he has 20 years of payments remaining on his current loan
versus 30 years of payments on the new loan.
3) Jack didn’t look at how much money would be owed at specific points in time. He didn’t compare the
unpaid balances in the future.

These mistakes mean that Jack is easily tricked by the math. Say he was analyzing a 7% fixed, 30-year loan.

The monthly payment for that is $731.84, which is less than his current 6%, $788 per month loan. Obviously, the 6% loan is probably better than the 7% loan—and it is.

So why is the monthly payment less for the 7% loan?

Because the payoff times are different!

When you make the payoff time 20 years, the 7% loan has a payment of $852. This makes it clear that the 6% loan is the best with a $788 monthly payment for the same time period.

Now that we’ve taken a look at the wrong way to compare loans, we’re going to spend the rest of our time comparing loans the right way!

Step one is to simply compare TRUE interest rates to get an idea of the overall cost of the loans.

The true rate of a loan takes into consideration all fees that are associated with getting the new mortgage. This value is easy to understand as well as easy to calculate using the DebtSmart Loan Calculator. Note: Video clip explaining how to use the software is here. You must watch the main presentation (cable/dial-up) to see this clip.

Let’s start with loan #1, the 30-year, 5.75% fixed, no-point loan, with $600 in total closing costs. You can see that the $600 closing cost affected the rate by only a small amount.

Now let's take a look at loan #2, 30-year, 5.25% fixed, 2-point loan, with no closing costs. Remember, each point is one percent of the loan, so that’s two percent or $2,200 in total fees. Continuing to use the same procedure, Jack builds a table comparing the true rates for all loan options. Note: Video clip showing the table is here. You must watch the main presentation (cable/dial-up) to see this table.

Oh, by the way, if you need to study this table, or any other slide in the presentation, just pause the video for a minute to take a closer look.

This table indicates that by fairly comparing the true rates for all his options, the 15-Year, 4.875% loan is the cheapest, but there is a risk to get this cheap loan.

The risk is the amount of time Jack must wait until he sees that true interest rate. Let me explain. The 2-point, up-front fee adds a big cost onto the loan in the very beginning. It’s only at the conclusion of the loan that the average rate, with all included fees, is 5.182%. But all along the way the rate is actually changing because of the closing costs.

Jack could spend the $2,200 to pay down his current mortgage and then owe $107,800, but instead he’s paying that as a fee to get future savings with the new, 4.875% loan. Therefore, the $2,200 fee adds to the rate of the new mortgage, but as time goes on, the savings from the lower rate becomes far greater than these up-front fees.

Now, to accurately calculate the time Jack needs to overcome the costs, of the new loans’ up-front fees, requires creating graphs for every situation. This would be very tedious indeed. But as I promised earlier, I do have a free tool that will enable you to calculate this break-even time as well as the true rate!

It’s the DebtSmart Mortgage Comparison Calculator that I created specifically for this video presentation. The calculator is a PDF file, which only requires that you have Adobe Acrobat Reader. There is no other software needed to run this program. Links to this free calculator can be found on this web page.

Some people may ask, “Scott, why didn’t you tell us about this calculator right away.” Well, the reason is that I want you to understand exactly how the math is done. I want you to know the logic required for comparing mortgages because this thought process is needed to compare all loans.

Now let’s take a look at the DebtSmart Mortgage Comparison Calculator and see how it works. Note: Video clip explaining how to use the software is here. You must watch the main presentation (cable/dial-up) to see this clip.

Using the DebtSmart Mortgage Comparison Calculator, Jack creates the final table needed to analyze all his loan options. Note: Video clip showing the table is here. You must watch the main presentation (cable/dial-up) to see this table.

This table consists of loan number (to identify it), time, rate, fees, true rate, monthly payment, and what I’m calling the break-even time, which is the number of payments required for the APR savings of the new loan to be better than that of the current loan.

The lower the true rate, the greater the savings. However, notice that it takes a longer period of time before Jack starts saving money on the lower rates. Additionally, the lower the true rate, the greater the payment. That’s because the banks get paid back more quickly with the greater payment.

So now it’s up to Jack to choose between all the loans since he can now compare them properly. Jack has to decide what’s most important to him. Specifically:

1) Is reducing the monthly payment his main reason for refinancing?

2) Can Jack come up with all the closing costs?

3) Is his bottom line the total savings for the life of the loan?
4) Does he want to reduce the risk waiting for the new loan to start saving money. This is a real risk because there is always a chance that a better refinance deal can come along during the period when the original loan’s unpaid balance would be less than that of a lower-rate loan, because of any closing costs.

After weighing all these factors, Jack decides that he doesn’t want to pay the closing costs but can afford to pay more each month. He also doesn’t want to wait too long before he starts seeing the savings from the refinance. So he finally settles on option #3, the 15-year, 5.375%, 0-point loan.

Personally, I would probably take the risk to get the greatest savings by taking the 15-year, 4.875% loan and pay the 2-point fee, but what I would choose isn’t necessarily the best for every situation.

There are many things to consider when refinancing and choosing a mortgage. Keep in mind that the main items to consider are the True Rate (the APR) and the break-even time (the time needed to remain in the new loan before you start to see savings from the lower rate).

Hi. My name is Scott Bilker and I’m the founder of DebtSmart.com and the author of many books on credit card and debt management.

by Scott Bilker - 01/09/2009

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