Should I refinance my house?

OK, disclaimer: I’m not a financial professional. That said, I do enjoy financial topics and am somewhat of a hobbyist. I’ve written articles in the past about how I do envelope budgeting with Gnucash for instance. That said, I’ve been thinking a lot on these interest rates lately and thought I’d write down a few thoughts.

Anyway, if you haven’t noticed, long term interest rates are quite low. At time of writing, my local credit union is offering 30 year mortgages at 4% and 15 years for 3.25%. Naturally, I got an email from the broker we worked with last time we refinanced saying we might be interested in another refinance. I figured lots of other people are in a similar type of situation so I thought I’d write down a few tips.

TIP 1: Don’t compare your new loan offers to your original current loan.

One of the biggest mistakes people make when refinancing is to directly compare interest rates. That’s right. You can’t compare todays 4% rate with your current 4.5% rate on your loan. Why not? Because it isn’t just the interest rate that determines how much money you pay to the bank. It’s also the number of months, or the term, of your loan. Since you’ve already paid your mortgage for a number of months, you no longer have a loan equal to what you had when you got your mortgage. Instead, you have a loan with the same payment and same interest rate, but the term is shorter and the principle owed is lower. This is the loan you have to compare with the new loan you’d be getting.

Example: You got a 30 year mortgage on $200,000 28 months ago and the interest rate is 4.5%. I calculated that to be a little over $1013/month payment for the 360 months. Your current loan is then a mortgage with 332 months left, same payment and same interest rate, but subtracting the principle you’ve already paid.

Now you can make a comparison.

Tip 2: Ignore what you’ve paid to the bank in the past.

You might be tempted to throw into the equation the fact that last time you refinanced it cost you an extra $7000 or so in closing costs. I’ve heard arguments like “It’ll take 22 months for this new mortgage to pay for the closing costs.” The reality is, whatever you’ve paid in the past is done, gone, history. Imagine walking into a store to purchase something for $10. The next day you walk in and need to purchase the item again but it is only $9. It would be illogical to decide not to buy the item because previously you had to pay more for it. Most people instead are excited that the price went down.

Back to comparing mortgages. Considering Tip 2, the only thing we want to look at is the future amount of money we will pay to the bank. For all these examples, I took a wild guess and said 6000 for closing costs. Here is your current mortgage:

So it actually ends up costing you more to refinance with this loan. Notice how the fact that you had to add to your principle to pay the closing costs pretty much negates the fact that your new loan has a lower interest rate. This loan isn’t that great a deal. Still, the difference is only about 4 grand more. Someone might choose this loan if they really really wanted to have a house payment that was ~60/month less than they were paying before. But then they’d just pay for it in the end.

Lets look at another couple scenarios:

Same loan, but you’ve paid on it for 7 years.

Wow. The new longer term makes a bigger difference doesn’t it. The longer you’ve paid on your mortgage the more damage the term on the new loan does. Even if it is at a lower interest rate, the fact that you’re still paying on it for, in this example, 7 more years really adds up and makes this loan completely not worth it in my mind.

Tip 3: Sometimes refinances are really really worth it. Especially if you could shorten the term from your existing mortgage.

Consider the loan from example 2. You’ve paid on this mortgage for 7 years and have 23 left to go. If you can afford the payment, perhaps you could jump down to a 15 year loan. Remember, rates are lower for lower term loans. Lets see:

Now there is a refinance I like. Instead of paying the bank 279k over the next 23 years you could give them 227K over the next 15. The only reason someone might not do something like this is if going from ~$1013 to a $1262 payment might be burdensome or risky.

Tip 4: Sometimes you can get the benefit of a refinance without the closing costs.

In all of these examples, I added 6k to the principle to represent closing costs. That always harms the results in favor of not refinancing. How does the loan look if we simply just paid extra on the loan instead of refinancing?

Example: Suppose we want to go from that 23 years left to 15 but don’t want to refinance and pay closing costs. What is the difference if we just pay more on our current loan.

In this example, I’d choose the refinance because going from 4.5% to 3.25% is just too big a difference in the interest paid. This would be the option for someone who can afford the extra payment but perhaps can’t qualify for a refinance. They can still pay their house off in 15 years for an extra $70/month and 12k to the bank.

Last example: Suppose the rate change isn’t so dramatic. Perhaps rates have gone up a bit or because of credit the lower rate isn’t available.

Pretty close to just paying extra on the original loan isn’t it. Perhaps there isn’t a very good reason to refinance. It was still less than paying at 4.5% for 23 years though. This might be a good option for someone who doesn’t have the discipline to pay extra on their mortgage but could afford to pay more than the minimum payment they are currently paying.

In summary, should you refinance? You’ll have to plug in your own numbers and make your own comparison to find out. Just remember:

1. Plug in the current terms of your mortgage, not the terms as they were when you bought or refinanced your house last time.
2. Don’t take into consideration points, closing costs or fees you’ve paid in the past.
3. Look for opportunities to pay more in principle and less in interest (lower rates and a lower term, not lower rate and a longer term.)
4. Don’t forget to consider simply paying extra on your current mortgage.

In the end consider this: those who refinance their house every few years will never pay it off!