Even at 3.25%, Refinancing Makes NO SENSE! Here’s Why

by Darwin on October 16, 2011

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.

The Result?

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?

{ 24 comments… read them below or add one }

Robert @ The College Investor October 16, 2011 at 7:21 pm

Some things to consider:
– You can have no closing costs for a higher rate as well. Many lenders don’t tell you this. Every 0.25% gets you about $3000 towards closing. Would it now be worth it.
– For a rental, the tenants now pay off your loan quicker allowing for cash flow sooner


Darwin October 16, 2011 at 8:14 pm

Hmm, I’ve heard of this before, but never seem to find it actually offered. If it is offered, why don’t they advertise it? It seems odd, like they either offer it or not. So by this thinking, I could add say, .50 basis points for 6K (totally covering all my costs plus some) and get a 15 year at 3.75%? In that case, I’d re-run the numbers, but I’ve never found that type of offering where they flat-out wipe out the closing costs (usually, they sneak it onto the principal).


brent October 16, 2011 at 7:40 pm

I also did the math on refinancing and came to the same conclusion. But I will probably be too lazy to pay off my mortgage early.


Darwin October 16, 2011 at 8:15 pm

Too lazy… or perhaps, just a savvy investor? Just kidding, that’s the age-old pre-pay vs invest with extra funds exercise.


amanda l grossman October 16, 2011 at 8:01 pm

Very interesting analysis. We are currently looking onto refinancing for a two percentage decrease. However, we do like the freedom to move. More thinking to do!


cashflowmantra October 16, 2011 at 8:49 pm

I like your analysis and subscribe to a similar theory. I have refinanced in the past to lower my payment and improve cash flow but not to decrease the term. I like the lowest obligation possible and then increasing payments if it suits my needs.


slug | sunkcostsareirrelevant.com October 16, 2011 at 10:59 pm

I’m with cashflowmantra. I re-fied down to 4 3/8% last year for 30 years and currently pay a slightly accelerated schedule. I like the guaranteed return in these volatile times but also the flexibility to pay less in case of emergency.


Darwin October 17, 2011 at 9:33 pm

Market returns of 9% per annum are no longer the expectation!


krantcents October 16, 2011 at 11:10 pm

I looked into refinancing with similar results. Only I would be refinancing a 5% 25 year mortgage with approximately 6 years left with a 5 year ARM at 3.1% mortgage. I think the closing costs were $2,400. If I increased my payment, I could pay it off in 5 years and save the difference in interest. Part of the reason is I have a small mortgage balance.


Darwin October 17, 2011 at 9:33 pm

Man, I live in the most expensive state around!


PKamp3 October 17, 2011 at 11:39 am

Yeah, the math doesn’t make sense for a lot of people who are considering refinancing. The number of fees that go into a refi are pretty astounding. I’m sitting on 4 and a quarter for 30, but I paid some points (well, closing credits did, haha) so I don’t want to touch it for a while anyway.

What about your rental properties? Perhaps you can refinance your main home and pay down some rentals at a higher rate while moving the debt to allow it to be written off? Might be interesting.


Darwin October 17, 2011 at 9:35 pm

My rental came with a seemingly high rate (for residential), but apparently a steal for commercial. We couldn’t get a typical residential loan since this was college campus, multi-property, etc. So, we got 5.5% with 25% down, which apparently is pretty good compared to the other options out there (we had other quotes at 6% OR…. no thanks, we’re not lending).


Money Beagle October 17, 2011 at 11:39 am

We’re going from 5.875% on a 30 year loan to 3.375% on a 15 year loan. We’re 4.5 years in on the original, so the net savings total will still come out to over ten years. It’s only $160 per month more, and the overall net savings from now forward will be around $70k and that even takes into account the projected closing costs, so it’s well worth it for us. I guess 2.5% is a lot better of a spread than 1%. If we were going to 4.875% it probably wouldn’t be as much of a slam-dunk.


Darwin October 17, 2011 at 9:35 pm

That’s a pretty good-sized spread.


egregg October 17, 2011 at 6:44 pm

I was in the process of refinancing. Our current rate is 5.75% on a loan we got in 2007. For us the best option was to switch to a 5ARM because we plan on moving in 5 years. After all the calculations it made sense, we’d lower our monthly payment by $300 and break even in 10 months. Everything was going great until we got the appraisal report yesterday. House is worth less then what we owe. Even if we wanted to put $2000 toward the principal to have it reach the value the PMI would be so high it would be worth it. So, very discouraging to have a house that is worth nothing.


Darwin October 17, 2011 at 9:37 pm

hmm, that happened to me with prior refi – well, not a net loss, but I had to bring extra cash to closing in order to stay out of PMI even though I had initially put down 20%. I figured it’s money that we owe on the house anyway, so by paying some additional principal to get the lower rate and stay out of PMI, it was worth it. In your case, you’d have to pay in another 20% just to beat the PMI. Not sure how big your loan is, but that could be quite a large chunk of change.


Ash @ Sterling Effort October 17, 2011 at 7:56 pm

Excellent perspective. It’s important to not get fooled by the numbers and really think how these things will affect our lives. You won’t find me refinancing any time soon…my rate is 2%!


Darwin October 17, 2011 at 9:38 pm

2% ?! Holy crap, that’s like a negative real interest rate! Is that typical across the pond?


Ash @ Sterling Effort October 18, 2011 at 10:02 am

No, it’s not typical but it’s still awesome!…and I only put about 12% down! I chose a mortgage, just over 2 years ago, that was fixed at 6.89% for two years before tracking the Bank of England base rate + 1.5%. You can’t buy a tracker that tracks that tightly nowadays so I guess my decision of taking this mortgage has paid off, as long as the base rate stays low. I have a tenant and she more than covers the the interest on the mortgage. In fact, she’ll be covering the mortgage until the base rate reaches 3%, which won’t happen any time soon looking at today’s environment. Good times.


IndenturedServant October 17, 2011 at 8:19 pm

I just refi’d a 30 year, 6% mortgage into a 15 year 3.75%. We had 24 years left to pay and payments including tax & ins were $606. Payments are now $648. Closing costs on the refi were $906 which were paid out of pocket. We only refi’d the existing balance adding nothing to it. We got to skip two payments which were saved and applied to the principal with the first payment on the new loan.

Whether he was correct or not, our banker ran numerous scenarios including applying the closing costs to principal on the existing loan and increasing payments to match the new payment. No matter how he ran them we came out ahead. From memory, I believe we shaved 9 years off the term and $35k in interest while bumping the payment only $42. Did we do ok?


Darwin October 17, 2011 at 9:39 pm

Sounds pretty impressive! You had quite a nice spread. I suppose part of my problem is the starting interest rate is already relatively low.


101 Centavos October 17, 2011 at 10:07 pm

I think we’re done with re-fis for now. I don’t get these high bank fees either, and the banks unwillingness to negotiate them.


Financial Samurai October 27, 2011 at 5:15 pm

1% rule? My rule is 0.5%! lol

I just refinanced my primary down from a 3.625% 5/1 to a 3.25% 5/1. It was easy, they baked in all the costs, stayed with the same bank, and now my payments are lower and I have a 5 year longer lock.


Darwin October 30, 2011 at 12:57 pm

Who’s your lender?!?!

Each time I inquire about these “no cost” refis, I’m told they’re not even legal. The lender must just charge you the costs in some other manner like adding it to the back of your mortgage or charging you a much higher rate. But title fees alone are like $4K. What are they in CA?


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