How to know if mortgage refinancing makes sense
If you took out a mortgage with a 7.5 percent interest rate in 1994 and still have it, refinancing in a 3.5 percent market is a no-brainer; you don't need much analysis to know that refinancing into today's rates will pay. The only possible reason a borrower would still hold such a mortgage is a marked deterioration in his credit, the value of his home or in his mental capacity.
If you took out a mortgage with a 7.5 percent interest rate in 1994 and still have it, refinancing in a 3.5 percent market is a no-brainer; you don't need much analysis to know that refinancing into today's rates will pay. The only possible reason a borrower would still hold such a mortgage is a marked deterioration in his credit, the value of his home or in his mental capacity.
If you took out a 5.5 percent mortgage in 2004, the case for refinancing is not as strong but, barring deterioration of the types mentioned above, it is strong enough to move with confidence.
The challenging case is when your mortgage is at 4 percent and was taken out in 2014. This is a situation where the rate reduction might or might not be large enough to offset the costs of the refinance.
This article will explain the valid approach to answering that question and critique an invalid approach used all too often by loan officers.
A refinance pays if the sum of all the costs arising from the refinance during the period you expect to have the mortgage is less than the sum of the costs of the old mortgage over the same period. Costs on only the new loan include points and other origination charges paid at closing. Costs on both the new and existing mortgage include monthly payments of principal and interest, mortgage insurance premiums if any, and lost interest on upfront and monthly costs. In both cases, tax savings and the reduction in loan balance must be deducted from total costs.
Yes, this is a formidable list, but I have made tackling it easy for you with a refinance calculator on my website (http://www.mtgprofessor.com/calculators/Calculator3a.html).
Calculator 3a computes the refinancing of one FRM (fixed-rate mortgage) into another to lower net cost. The calculator will prompt you for all the required inputs and indicate why they are needed. This calculator assumes that you have only one fixed-rate mortgage that is refinanced into another, and that you don't take any cash out of the transaction. Other refinance calculators are available for borrowers who have an adjustable rate mortgage, or a second mortgage, or want cash from the transaction. See Find a Refinance Calculator.
Calculator 3a indicates that the borrower with a 4 percent 30-year mortgage he's held for three years would benefit by refinancing it into a new 3.25 percent loan, and benefit even more by selecting a 15-year mortgage at 2.5 percent. With a loan balance of $360,000, the savings over 10 years would be about $17,000 on refinancing into a new 30-year, and about $49,000 when the new loan is for 15 years.
Another approach to whether or not you will save on a refinance is to calculate a break-even period - the period over which costs of the old loan and the new loan are equal. The larger the spread between the new interest rate and the rate on your existing loan, and the smaller the cost of the new loan, the shorter the break-even period. If you are confident that you will have the new mortgage longer than the break-even period, you will benefit from the refinance. Calculator 3a shows the break-even period, in addition to the cost comparison over the period you specify.
But beware! The break-even period is not the cost of the new loan divided by the reduction in the monthly mortgage payment. Many loan officers use this rule of thumb, which completely ignores how rapidly you pay off the new loan as opposed to the old one. Borrowers following this rule would never refinance into a shorter term loan because of the increase in payment, although the total benefit including the pay-down of the loan balance is substantially greater on refinancing into a 15-year loan, as indicated above. The rule of thumb does not work for any borrower who is concerned with how long they have to pay, which should be every borrower.
The answers generated by refinance calculators are no better than the current mortgage prices the user must enter to make the calculators work. The calculators on my website were developed at a time when users were on their own in finding the prices at which they could borrow in the current market. But that is no longer the case. You can now price shop and assess whether a refinance will pay in a single operation on my site.
Follow the Refinance Mortgage Shoppers path, which at step 2 will give you an input form that includes all the factors that affect your mortgage price in today's market, and also includes information about your current mortgage. The program will show the costs over the period you stipulate, using the best prices quoted by the lenders who report their prices to my site, on all the new loans for which you qualify, and also for your existing mortgage if you retain it. You can thus shop for the best terms on a new loan, and you can select the new loan type that generates the largest saving over your current loan.
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.