There’s an old rule of thumb that if you can refinance at an interest rate 1% or more below your current rate, it’s a good deal. That advice is too broad and may not be true in many circumstances. It doesn’t take into account so many factors like how far into the current loan you are, what the transactions costs are (they vary widely by state and financing outfit), what your future plans are for moving. Taking this a step further though, with record low mortgage rates, many people are jumping from 30 year loans into 15 year loans. This begs the question as to what the right interest rate spread is if jumping from a 30 down to a 15 and my assessment is that the spread must be MUCH wider than 1% to make sense. While it’s admirable to seek to pay down your loan quickly, it’s a move that may not provide any benefit, but add risk to your financial situation. Here’s Why:
My Refinance Assessment:
Current Term: 30 Years
Current Rate: 4.625%
Remaining: 27 Years
Current Monthly Payment: $1727
Proposed Term: 15 Years
Proposed Rate: 3.25%
Closing Costs: $5000
Future Monthly Payment: $2339
Additional Monthly Payment: $612
Loan Paid Off in 15 Years as Opposed to 27
The closing costs are pretty high in my state because of the title search which runs around $4000 or more. It seems like a giant scam to me in a day and age of electronic records and databases, but that’s a standard cost nonetheless. Then, there are the usual appraisals, document fees and the other 99 things they get you with at closing, so as a round number I assumed $5,000. While some firms claim to offer a “no-closing cost” transaction, that’s a misnomer, they simply add the fees into your mortgaged amount or jack the rate on you to account for their out of pocket expenses. So, $5,000 it is.
Why a Refi Doesn’t Make Sense
It might sound like a no-brainer, right? I’m cutting my term almost in half and only paying $612 extra per month! However, I did a scenario analysis.
What Would Happen If I Did the Following:
- Set up a Pre-Payment model to compare (Is Pre-Paying a Mortgage Responsible or Obsessive?)
- Make a single pre-payment of $5,000 this month (to equate to my closing costs)
- Voluntarily pre-pay an additional $612 per month every month moving forward (the higher monthly payment under refi scenario)
This would essentially mimic the same out of pocket expense and additional monthly payments I’d have under the new loan.
There’s a spreadsheet to calculate loan repayments and it spit out the final payment date as Sept 2027. If I basically implemented the terms myself (albeit still at my old higher rate), the loan is paid off in less than 16 years. That’s right! I’d basically have the same loan, and have saved a only few months of payments.
But what’s the trade-off?
In taking on the 15-year loan, with very little benefit, especially when discounting those savings back to present day (see how Present Value works), here are the risks:
- Chances are, I’d have to bring even more cash to closing, like I did 3 years ago, since most US homes have lost even more equity. (See the Growing Trend of “Cash-In” Refis due to loss in equity).
- That’s depleting $5,000 today from my emergency fund or investment accounts that could be used in the event of job loss, or to realize higher returns.
- I’m locking myself into a higher monthly mortgage commitment for no real benefit. In the event of job loss or otherwise, that $621 per month might make a meaningful difference in the ability to pay.
So, why bother? I’m trading a lack of security and near-term cash for shaving less than a year off a mortgage 15 years down the road!
I looked at a 10 year loan with an even lower rate and the results are even worse. What I came to find is that the bigger factor in mortgage outcomes is the term, not so much the rate. If I drop a 10 year loan to like a 2% interest rate, the results barely budge. Interesting to say the least! Basically, once you start cutting down to 20 years, 10 years, and lower, the term of the loan matters way more than the rate – so much so, that the rate almost doesn’t matter!
How About You?
Do you Refinance Any Time the Rates are Much Lower or Think It Doesn’t Make Sense Sometimes?