IS IT WORTH IT JUST TO LOWER MY RATE BY A HALF OF PERCENT
IS IT WORTH IT JUST TO LOWER MY RATE BY A HALF OF PERCENT? The power of interest rate on a debt as large as your mortgage is often difficult to grasp. I’ve heard several variations of what “the rule of thumb” apparently is and all are wrong. All are also right….the problem with the rule(s) of thumb is this; they don’t take into account how you are approaching the transaction and how your mortgage planner, if you have one, is using his or her knowledge to properly structure the new loan and how that structure will impact you in the short run, mid‐range, and long term in reference to your overall financial game plan. We’ll look at a couple scenarios by looking at some of the “rule of thumb” myths and some of the objections people have to the refinance and see why they are often misleading or at best not the whole story. 1) “It’s not worth it unless I can lower my interest rate by 2%.” (or 1.5%, or 1%.....I’ve heard multiple numbers plugged into this one so my rebuttal will apply to any and all of these.) Well of course saving 2% is fantastic but what gets left out here is actually the reason people are putting that number there in the first place. The real question or point of emphasis should be, “What is the cost of the transaction and how does that cost get justified based on what my goals and objectives are?” Considering the nature of the questions, it doesn’t lend itself to “One size fits all” target rate reduction number that would work. Think about, if you have a mortgage balance of $150,000 and could lower your rate by 2%, a very large change in rate, but it cost you $10,000 it wouldn’t make sense. $150,000 loan amount at 6.5% = $948.10/mo $150,000 loan amount at 4.5% = $790.03/mo Savings at lower rate = $188.07/mo Cost of $10,000 / Savings of $158.07 = 63 months or 5 years, 3 months just to break even. Too many things can happen over 5 years to know whether or not you would ever see that benefit so I would say no, you don’t move forward on this one. However, if you take that same loan and reduce the interest rate from 5.25% down to 4.25% and the total cost is $1,000…..lets look again: $150,000 loan amount at 5.25% = $828.31/mo $150,000 loan amount at 4.25% = $737.31/mo Savings at lower rate = $90.46/mo (much lower monthly savings…..) Cost of $1,000 / Savings of $90.46 = 11.05 months. Less than 1 year! So these two examples show that “I need to save 2% to refinance” is flat out wrong because we’ve seen that in one case, 2% isn’t worth it when the cost is brought into the equation and the other has a 1% savings and makes total sense because everyone has a better idea of where their life will be in 11 months. If recouping the cost inside of 11 months is still not quick enough then the conversation needs to be about your purchase mortgage and which Real Estate agent I would recommend. 2) “But if I refinance, I’m just starting over for another 30 years.”
I hear this a good bit and it’s like nails on a chalk board to me. The term of the loan is just one piece of the equation. The term tells us the maximum time until it has to be paid off and sets monthly payments accordingly. Unless you have a pre‐payment penalty, something I never write, there is no rule against paying any of or the entire loan off at any point so you are in total control of the loan, the amortization or term simply gives us a deadline and a means to determine minimum monthly payment. So really, does the term matter at all provided you have an actual game plan in place? Example: Objection: Well your proposal is going to cost me $1,000 in closing costs and it’s going to put my loan back out to 30 years, in order prevent out of pocket cash for the costs and setting up the new escrow account your loan amount is higher than my payoff, and the monthly savings just isn’t enough. I just don’t think it makes sense….. In the words of Lee Corso, not so fast my friend……. Existing loan: $255,000 at 4.875% with 28 years remaining on the term. (336 months) $1349.48/mo P&I payment $248,787 remaining balance $453,425.28 total of remaining payments New loan: $250,000 at 4.25%, 30 year fixed rate mortgage. (360 months) $1,229.85/mo P&I payment, savings of $119.63/mo $442,745.91 total of all 360 payments Comparing the two takes looking at several strategies, below are different ways to handle the savings. You have to plug it in “somehow or someway” to get a feel for how the reduction in rate impacts your overall financial agenda. Option 1‐ Do nothing and just let monthly difference fall into your day to day budget/spending. This to me is the least attractive but it must be considered. To compare it under the “do nothing agenda” you have to look at the sum of payments remaining vs. sum of all new payments. You would save $10,679.09 and from that you’d have to subtract your cost of $1,000 giving you a “net benefit” of $9,679.09. so that does make sense but I would never advise this be the path because that’s a lot of money at once but over 30 years you wouldn’t really and truly know the difference. Option 2‐ You’ve budgeted for the existing payment so why not just keep making it? Making the same payment but on the new mortgage at the lower rate we begin to see the separation. Under that scenario a couple of things happen. The total dollar amount paid falls off a cliff…. It’s now $407,451.44 which is lower than paying the same amount for the next 28 years. How does that happen? Because you’ve now paid the loan off in 302 months which means you have effectively cut 5 years off the term of the new loan and cut 3 years off the term compared to the existing loan.
This is the best way to show that term of the loan is irrelevant and it only sets the bar at it’s lowest point. The new loan that “takes me back out to 30 years and increases my loan amount back up to $250,000” actually cut 3 years off the existing loan and saved you $45,973 in payments even with the increase of the loan over actual payoff. So worrying about the term and increased mortgage amount couldn’t be a bigger waste of your energy. Worrying about the plan is where you need to focus your efforts. So…. Total of payments remaining by staying put: $453,425.28 Total of payments at the lower rate but making the same payment: $407,451.44 Total of dollars saved: $45,973.84 Minus your cost of $1,000 Net benefit of the transaction = $44,973.84. Now that’s a little bit different than option1 isn’t it? Look at it another way or to annualize the benefit of the transaction, divide the net benefit by the 25 years until the loan is paid in full and it’s $1,798.95/year. Or an almost $1800/yr pay increase without tax…… All with $0 change to your existing monthly budget! Option 3‐ My personal favorite….Take everything from option 2 and we’re going to make one simple twist. Rather than apply the savings as additional principal pay down, we took that $120/mo and made a monthly contribution to an interest bearing account and created a second appreciating asset to build our net worth. Using an annual rate of return 6%*, things look like this: * 6% is a very conservative projection for long term investments considering that the overall return seen by S&P is 11% average since 1957. We’re not overstating the potential, we’re understating it tremendously. We are all aware that nothing is guaranteed and there is always “something that could happen” you can’t take it to the bank but then again, paying off your loan to zero does you no good either if the house is then worth $0…..it COULD happen but your assumption that it won’t is no more guaranteed than my assuming a 6% paltry return on an investment account. $120/mo invested into a conservative, managed account at 6% average return: The balance in 10 years: $23,304 The balance in 23 years: $78,993 Point at which the balance in the investment acct. is equal to the balance of mortgage: 23.67 years. In other words, at this point you actually own your home free and clear…..how? Because you have the cash on hand to zero out the balance of the mortgage should you so choose based solely on the balance in the new investment account. This actually cuts another year off the loan and compared to the existing loan you are debt free 4.5 years sooner. (Comparing to the additional principal payment approach you pick up another 1.5 years off the mortgage.) Yet again, all without any adjustment at all to your existing monthly budget!! So term is yet again rendered a pointless place for your concern.
Conclusion to this rebuttal is simple…..4.875% is a low interest rate, but 4.25% is a lot lower. If your cost to achieve that rate is held low AND a plan is put in place for how to handle the realized monthly savings, who cares whether or not the maximum term of the loan is extended back to 30 years. Can you imagine how these numbers would look if your current mortgage was at 5.25% or 5.5% or 6%? It exponentially increases the urgency to visit your situation. 3) “You say the cost is $1,000 but there is another $2500 in “prepaids”….that’s money I have to spend so it’s a cost and should be factored into my cost/benefit analysis right?” Not really….here’s why. If you escrow your current mortgage, which most people do. Every month your payment includes 1/12th of your total homeowners insurance premium and 1/12th of your yearly tax bill. The servicer to whom you make your payments then takes that portion of the monthly payment and puts it into a savings account. (To simplify it we’ll call it a savings account.) Then every year when your insurance and taxes are due, they cut a check to the agent or the county/city to make sure that both items are paid on time. That said, if you refinance and close today, your first payment will be due on November 1st of this year. If your insurance premium is due in November, you’ll be about 12 months short right? you never made a payment, it came due, and the escrow account balance would otherwise be $0. Same thing with taxes, however many months you would pay between now and when the tax bill is due will be less than what needs to be there. But you have been making those payments to the other mortgage right? Well that savings account is still there and you still have money in it and it’s still YOUR money. In other words when the refinance closes and the old mortgage is paid off, they have to send you back that money because you paid it but they never had the chance to pay the premium or the tax bill and you get it back. So if you have a refinance with that $2500 in prepaids, roughly $2000 (estimating only based on a lot of experience) would be in the existing escrow account and therefore would be coming back to you. that’s still $500 short though….. The rest will be interest. When you make your payment on September 1, you actually paid for the interest accrued over the month of August. You’ve paid in arrears, this is the way all mortgage loans work and is the opposite of rent. When I pay rent on 9/1, I actually pay for the right to live there over the month to come, the mortgage pays for the month that was. So using our closing of today from the escrow example, your first new payment would be due on 11/1 right? which would pay for Octobers interest right? Well if you never make an October payment then how are the remaining days of September paid for? Bingo….prepaid interest at the closing. So the difference between the escrow refunds and the prepaids on the new loan, 99% of the time, is going to be negated by the fact you miss a payment. This is VERY important and is not to be neglected in your calculations on cost/benefit. In short, the prepaid line item on your good faith is not part of the equation on the cost/benefit but will factor into your best execution structure of the loan. (Do I get a new loan for the exact pay off and bring $2500 to the table or do I write the $2500 into the loan and negate my out of pocket? Things like that
should be addressed with your mortgage professional based on current position financially, needs/wants, convenience, upcoming expenses, etc.) As we just worked through these examples, hopefully you noticed the following: ‐ The amount the interest rate is reduced and the benefit in that reduction isn’t the same thing. I’m not saying “rate isn’t important” but it’s not important as the raw number itself as much as it’s only important in how effects your plan. ‐ Term is only part the equation and not the single piece to make your decision on. The term of the loan is relevant only in how it effects the minimum monthly payment. ‐ Cost isn’t a cut and dry number and money has to be accounted for in areas that aren’t truly costs. Any mortgage, large or small, needs to be approached from a big picture planning position and not from any rule of thumb. By using any of these objections/assumptions to the refinancing process you are severely increasing the chance that you will let today’s fantastic opportunity slip by. How much benefit would you get from seeing the additional $50k+ added to your net worth over the next 23 years? Retirement planning or retiring early, paying college tuition, eliminating other consumer debt, caring for your parents as they age, having your first child (or 2nd, 3rd, etc…..) and the list goes on. These are topics that are of concern and should be discussed with your mortgage professional on how best to achieve these goals. Discussing how much the rate is dropping is getting off the real topic if you think about it in those terms.