How Do I Know When to Refinance?


It’s Not as Simple as You Think

Interest rates are very low today – lower than at any time since November 2016.  When that happens, you’re inundated with advertisements from mortgage companies enticing you to lower your payments, or pull cash out.  Many of these advertisements use very attractive math to show you how much you’ll save.  Don’t fall for it.  Instead, let’s answer the question on everyone’s mind: “How do I know when to refinance?”

Throw out the “rules of thumb”

Many well-meaning folks advise you to refinance as soon as you can lower your interest rate by a certain amount.  (I’ve seen financial writers say 0.500%, and mortgage “experts” say 0.250%.)  This advice is nonsense, because it doesn’t account for how much your new loan costs, how long you’re going to stay, or how you plan to pay off the loan.

More on this in a moment.

Payback analysis is good math, but bad thinking

When to refinance - payback analysis
Figure 1: Traditional Payback Analysis

The easiest (and thus most common) analysis used is the payback analysis.  It’s very simple.  Take a look at figure 1.

Let’s say you want to refinance your $400,000 loan that is currently running at 4.250%.  Your payment is $2,166.95 per month.  You are considering a proposed loan of $400,000 at 4.000% at zero points.  Lender, escrow, title and recording fees will total $4,500, so that’s the cost of the new loan.  The payment on the new loan will be $1.909.66, for monthly savings of $257.29.  You will recoup your $4,500 in 17.5 months.  Not bad, right?

Modified Payback Analysis
Figure 2: Here’s the full picture

Hold on – not so fast.  The math is correct, but is the thinking right?  What’s wrong with it?  Take a look at figure 2.

Your current loan has 25 years left to run on it, while the new loan will take 30 years to pay off.  If you keep your existing loan and pay it off your lifetime cost will be $650,086.  The new loan will cost $687,478, or more than $37,000 more because you refinanced!

Your monthly payment is lower, but your lifetime cost is more.

The trouble with the payback analysis is that it treats your entire monthly payment as a cost, but it’s not.  The interest portion is a cost, but the principal portion is actually just transferring money in your bank to equity in your house, by eliminating debt.  And the proportion of interest to principal changes every month, so using the amount of interest on the first payment can be very misleading – although better than not accounting for it at all I suppose.

Moreover, the payback analysis doesn’t take into account how long you intend to live in your home.  Most folks don’t keep their home (or even their loan) for 30 years. 

So, how do I know when to refinance?

To fix these shortcomings, we need to do only four things:

  1. Estimate how long we intend to stay in the house
  2. Determine how much interest we will pay on our existing loan in that time
  3. Determine the up-front cost, plus interest to be paid on the proposed loan
  4. Compare the total cost of the existing loan with the total cost of the proposed loan

Determining the interest paid on each loan usually hangs folks up, but it doesn’t have to; it’s really quite simple.  You already know:

  • What the total cash outflow of each loan will be – total payments over the period plus costs, if any, for the proposed mortgage
  • How much of that is going to go to principal, which we can find by comparing the present principle balance to the balance at the end of the holding period.  (The difference is the amount of principle you’ll have paid.)

If you don’t want to bother calculating the balance at the end of the holding period, simply look at an amortization table.  They are easy to find online, and when you got your loan you probably were given one when you signed papers.

For the engineers and finance geeks (like me) in the room, the balance at the end of your assumed holding period will be the present value of the remaining cash flow.  For example, if you have a 30-year loan, in 7 years you will have 23 years remaining.  Find the present value of your monthly payment at the note’s interest rate for 23 years – that will be your balance after 7 years.  OK, enough geeking out…

Let’s see what a more valid analysis would look like:

A good refi benefit analysis accounts for interest
Figure 3: At least now we see how much interest we’re saving

Should I refinance my mortgage?

First, we’ll start with the payback analysis but examine what the interest savings is as well.  In figure 3 you’ll see that if we compare the payment “savings” with the cost of the loan we get the same result – 17.5 years.  But we also note that while the payment is going down $257.29 per month, the interest savings is only $83.33!  We don’t do a payback analysis on this number because that is the interest difference in the first month only, and it changes from there.

When to refinance? Look at total cost
Figure 4: Look at the total cost of your existing loan versus your proposed loan

Then let’s look at the total cost.  In figure 4, you’ll see that your current loan will cost you $108,772 over the next 7 years, our chosen holding period.  (You should use whatever holding period makes sense given your plans.)  The new loan, on the other hand, will cost $109,149 over 7 years when you add up the interest plus the $4,500 in closing costs. 

Refinancing with the proposed loan will cost you $377 more over the next 7 years than if you did nothing.  How do you feel about refinancing now?

But there’s more.  If you just keep your existing loan, in 7 years you will owe $326,748 on your existing loan.  If you refinance into the proposed loan you will owe $344,238 – $17,490 more than if you did nothing at all!  Why?  Because you’ve started amortizing from the beginning again, and the first few years you pay very little principle.

Some sharp clients have pointed out that yes, that may be true, but they could invest the $257.29 in extra cash every month.  Fair enough, if you put that money in a savings account bearing 2.25% (my random savings account number) then you will have $23,383.53 in the account after 7 years.  If you do, then you have come out ahead by refinancing (and saving the difference.)

This analysis doesn’t mean you should – or should not – refinance.  It just means you should think it through, and not make your decision based on rules of thumb or a payback analysis.

Finally, if you want to try a clever strategy to see if you could make it work, you could pay your new 30 year loan off on a 25-year schedule (by making higher payments) to match the loan period you have on your current loan.  What would that look like?

Payback Analysis with Equivalent Amortization
Figure 5: If we pay off the proposed loan faster it might make more sense

Look at figure 5.  You can see that your payment now lower by only $55.61, rather than $257.29, and the payback period increases to 80.9 months – barely less than our assumed holding period.  However, the total cost of the loan over 7 years is $2,195 less than your current loan, and you will owe $2,024 less at the end of 7 years.  You will be ahead by $5,054.08.  (See Figure 6 below)

Strategic approach to the refi benefit analysis
Figure 6: If we pay off the proposed loan more rapidly, we get a more realistic analysis

So, should you refinance?  It’s a personal call, but now you have good, solid data upon which you can base your decision.

For an Excel-based copy of this analysis, please click here and download the spreadsheet used for this article.  (It is named Refi Benefit Analysis)  It is free to download and use.

Alternatively, if you wonder whether you should refinance or not, call or email for a free customized analysis.

Casey Fleming, Author The Loan Guide: How to Get the Best Possible Mortgage (On Amazon)
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This article represents the opinions of Casey Fleming, and not necessarily those of C2 Financial Corp. This analysis was prepared with the best information available at the time it was written. Neither Casey Fleming, nor C2 Financial Corp., have any magical insider information about bond markets, real estate markets or mortgage markets that would make economic projections any more reliable than any other source. No warranty is made that the outcome will reflect the projections in this article, and neither Casey Fleming nor C2 Financial Corp. are responsible for decisions that you make regarding your own choices about your real estate or mortgage or those of your clients.

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