There are a lot of reasons to refinance a home, and a lot of reasons (probably the same number) NOT to do so. Mortgages Unzipped has provided a good number of analyses recently, including really good ones from Evan Vanderwey and Ken Cook. This post isn’t meant to explore all of the reasons, just to offer one possible calculation for those out there that are hesitant to refinance because doing so 1) resets your mortgage to 30 years again and 2) sticks another dollop of closing costs onto the loan. Maybe it’s because I do lending in Utah, but it seems that for many people these days, their fondest dream is not to have a mortgage at all. That’s fine, and I encourage my clients to think that way. That does not mean, however, that you shouldn’t refinance.
Instead of looking at your loan as a new set of requirements, look at how to fit your new loan into your current requirements. Stay with me here. This is going to require you to do some actual forward planning. But it won’t hurt much, I promise.
First, figure out when you want your home paid off. Yes, put an actual date on it. If your 30-year mortgage closing was in October of 2009, that means that you’ll pay the loan off more or less in October of 2039. Sound like forever? Okay then, shorten the time. Put that date anywhere you like. At this point, it doesn’t matter.
Second, now that we have a date, we have to figure out what payment pays the loan off on that date. Alternatively, we have to figure out what lump sums at what points will pay the loan off on that date. The earlier additional funds are paid on the principal balance, the greater the impact those funds will have. There are excellent calculators out there that can help you do this math. For instance, on a $200,000 loan, if you want to cut your 30-year, 5% loan down to 18 years, you pay an additional $316/mo, and there you go. You can accomplish the same thing by putting $3500 down every year in a lump, plus $5000 right at the beginning. And so on.
NOTE: You’re thinking this is backward. You’re thinking that what you should do is figure out how much money you can put toward your mortgage, then see how fast it will be paid off. And of course you can do that, but I wouldn’t. This is not how savvy people do this calculation. They know that if they have a target to hit, they’ll move Heaven and earth to hit it. So they set a date, then they figure out how to arrange things to make that date. This process makes it much more likely that the plan will work.
Third, now that we have the payoff date set and the payment calculated, let’s find out if the refi gets us to that date faster, or with less cash expended. Using the same scenario above, the current loan already has a low interest rate, and it has already been paid for 11 months. That’s an advantage for the current loan. However, what happens if you refinance it to the current rate, say, 4.5%? The principal balance after one year is about $197,000. We’re going to add $5000 in closing costs to that, making it $202,000. Since you’re looking to pay off, not to drop your payment, we’re going to take the payment you skip (all refinances have a payment skip built in) and pay it as a principal reduction on the new loan. That drops our principal to $200,900. Then we have monthly payment savings of $56/mo (from reducing the interest rate). Doesn’t sound like much. But over time, it is the difference-maker. If you target your 18-year payoff, as above, you can pay $30 less per month and still hit it. If you keep the payments at the same level, the refinanced loan pays off one year sooner and saves you $10k in interest.
And that means (in this case) that you should refinance, if your goal is to get to zero in the shortest time, with the least cash expended.
Now, you can do these calculations yourself, but I wouldn’t. Your mortgage professional – you do have one of those, right? – can do those numbers in seconds, while you’re doing what you do for a living.
If you need to lower your payment, then this calc won’t help you. But for those that are aggressively seeking zero, as we say, this is a handy way to figure out how best to get there.