There are many reasons a person may want to refinance a mortgage. If lower interest rates are available due to improved credit of the borrower or a lower interest rate environment, the borrower can save interest expense. If the borrower wants to lower the payment, perhaps because it has become harder to make it each month, the term can be extended with a refinance. Refinancing can be one way to get rid of Private Mortgage Insurance (PMI) if the ratio of mortgage to home value has decreased. Sometimes people want to borrow against the equity in their home for home improvement projects, education or paying off higher rate debt. As each person’s situation is unique, this article addresses issues borrowers should consider when contemplating a refinance, as well as common misconceptions.
One misconception about home mortgages is that the interest is paid upfront and then the principle is paid later. There is some truth to this in that a larger portion of a fixed mortgage payment is required to cover the interest portion early in the loan when the balance outstanding is higher. This has nothing to do with a lender front-loading interest like a sports team might front-load an athlete’s contract with a signing bonus. Interest in any month can be calculated as the outstanding balance times the interest rate. The monthly payment is calculated to cover the interest payment each month and to have enough left over for principle to retire the debt in the loan term. For instance, for a thirty-year mortgage at 4%, 70% of the first payment would go to cover the interest expense, while only 0.33% of the final payment would be for interest. This is not because the loan becomes cheaper, but because it is already 99.5% paid off, leaving very little balance to accrue interest.
A second misconception about mortgages is that a borrower somehow gets credit for interest paid in the past, which would be lost if the loan is refinanced. This may be related to the first misconception. Interest paid in the past was to pay for debt owed in the past. There is no residual value in prior interest paid (other than perhaps as a tax deduction if it is in the current taxable year.) Just as it makes no sense to borrow more on a credit card because of past interest paid, mortgage interest paid in the past is irrelevant toward future decisions.
A final misconception is that mortgage choices should be compared using total interest paid. This ignores a basic finance concept called the Time Value of Money. Money available today is worth more than money in the future. Proper financial analysis uses the discounted cash flow method to compare alternatives. This method uses the cost of capital (think of the cost of other borrowing or the opportunity cost of investing the money) to discount future cash flows back to a present value.
With these misperceptions cleared up, let’s look at what to consider in a refinancing decision.
The easiest scenario to analyze is refinancing a mortgage with the same term as is left on the original loan. In this case, all costs of refinancing must be considered – loan application fee, appraisal, attorney fee, points, etc. The part that is still up for judgment is the duration of the new loan. If a borrower is likely to refinance again or to sell the home before the new mortgage is retired, using the entire term is inappropriate. Once the effective term of the loan is assumed, the question becomes a math problem. If the borrower can get a lower rate that more than offsets the upfront costs (and the headache of going through the process), the mortgage should be refinanced.
In cases where the new loan term is not the same as the original loan, the borrower must weigh the mortgage costs against other borrowing or opportunity costs. If the borrower has other debt, it probably makes sense to either borrow more to retire other debt or to extend the term to lower the payment so other higher cost debt can be retired more quickly. Conversely, the term can be kept roughly the same at the new, lower rate to lower payments and still pay the house off in a similar timeframe. The term could also be shortened, perhaps without increasing the payment if the new rate is enough lower, resulting in faster extinguishment of debt and less interest paid. Caution is warranted, especially in extending a loan, because the opportunity cost is only realized if the monthly savings is actually invested or used to pay down other debt. If it is wasted, the borrower may have nothing to show for the savings but a longer mortgage.
One idea that people should consider is refinancing a thirty-year mortgage with a fifteen-year mortgage. For example, bankrate.com currently shows an APR of 4.16% for a thirty-year and 3.67% for a fifteen year. This 0.5% spread has been normal for as long as I’ve been watching this. A thirty-year mortgage that is half finished is now effectively a fifteen-year mortgage, but still carries the thirty-year rate. Assuming no change in interest rates over the last fifteen years, borrowers could save a half percent (minus refinancing costs) by refinancing this loan. When rates in general have fallen, this becomes even better. One need not wait until there is exactly fifteen years left on the existing mortgage to refinance, as the lower rates may more than make up for a shorter term.
As an example, assume a hypothetical borrower took out a $300,000 thirty-year mortgage in June, 2009 at the then prevailing rate of 5.42%. The monthly payment is $1,685, with 241 payments left. (Assume the refi takes a month.) A new fifteen-year loan at 3.67%, including financing a 3% refi cost would yield a payment of $1,814 per month. This is an increase of only $130 monthly to pay off the loan five years earlier. If the loan is not refinanced and the borrower simply makes an extra $130 payment each month, the loan will be retired 28 months earlier. The refinance saves 32 months of payments at the higher payment level. If we apply a 5% discount rate, the future value of the refinancing at the original loan maturity is $70,044, while the future value of simply increasing the monthly payments with the existing loan is $2,271. (This is the future value of all cash flows relative to the status quo.) The present value of the refi is $25,821, while the PV of only increasing the monthly payment is $837. This analysis ignores taxes, and using different discount rates will yield different results, but in every case paying a lower interest rate is beneficial if refinancing costs can be more than recovered. Even better results could be obtained if the borrower’s credit improved and/or if the loan was originally a jumbo loan but is now a conforming loan due to lower balance and higher thresholds.
The chart below shows the discounted cash flow value (relative to staying with the original payment plan) of paying an extra $130 per month with and without a refinance.
Source: Author’s calculations
A borrower will likely pay 2-4% of the loan value to refinance a loan, but may be able to get a better deal if staying with the same bank. Alternatively, a mortgage broker can look across multiple lenders to find the best deal. There are online refinance calculators where one’s specific information can be used to calculate potential savings.
Cash out refinancing becomes much more than a math problem, and borrowers should be careful. If the refinancing is done to lower the cost of debt that already exists, people should probably first ask why the other debt exists. If it is a symptom of a problem that has not been corrected, rolling that debt into the mortgage may reduce in lower interest costs now and a larger problem long-term. From a financial perspective, using equity to get lower cost (and possibly tax-deductible) debt to retire other debt is a good move. Borrowers should consider keeping payments the same as the sum of the payments of the prior loans to retire the debt more quickly. Borrowing against equity to do home improvement projects is tempting, and we can justify that it improves the resale value of our home, but this is often just rationalization. First, the home may not be resold for many years, and by then, the shiny new home improvement project may not be so new, and stylistically could be dated. Second, home improvement projects almost always increase the value of a home by less than their cost, and sometimes significantly so.
Conclusion: Refinancing a mortgage can be a great way to take advantage of improved credit, lower interest rates in general, lower rates for a shorter term and/or better loan to value ratio. It can also be a way to consolidate debt from higher rate loans to lower rate loans, saving on interest costs. The important financial issue is whether the combination of the lower rate and the expected term of the loan is enough to offset the refinancing costs. The behavioral issue is whether the borrower will use the monthly savings toward long-term goals rather than short-term consumption. Understanding the basics of financial principles and how a mortgage works helps to make informed decisions.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The views expressed are the views of Jacob Rothman and do not necessarily reflect the views of Rothman Investment Management. This article is for educational and informational purposes only. Jake is not a licensed mortgage loan officer (MLO) and please consult with your local MLO before refinancing.
All financial information in this article is as of May 15, 2019 unless otherwise specifically indicated.
The content in this article is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals
Due to various factors, including changing market conditions, such information may no longer be reflective or current position (s) and/or recommendation(s). Therefore, no client or prospective client should assume that any such discussion serves as a substitute for personalized advice from a mortgage loan officer or financial planner.