While driving to work this morning, I heard an advertisement on the radio featuring Dave Ramsey, the well-known radio host and author who helps his listeners and readers get their financial life in order. He was advertising for a mortgage brokerage company, telling listeners to “control what you can control” during these uncertain times, and to consider a mortgage refinance. I don’t always agree with Dave Ramsey, but I thought that was some good advice. As humans, our brains don’t do well with uncertainty, and during a global pandemic there is a lot of uncertainty. For many people, their jobs, investments, health, travel plans, retirement plans, wedding plans and countless other important variables are up in the air. Focusing on that uncertainty can lead to wide range of emotions including anxiety, fear or anger, and with those emotions we can make some irrational decisions.
Instead of focusing on what you can’t control, focus on what you can control. One of those controllable variables is your mortgage, as was mentioned in that radio advertisement I heard. Mortgage rates dropped in March as many aspects of the financial markets were in disarray, and they continue to be attractive – so much so that refinancing activity is through the roof. The chart below shows the MBA Refinancing Index, which measures how many mortgage refinance applications are being submitted. The chart compares refinance activity with the 30-year Treasury Rate (inverted), which is a long-term interest rate that is closely correlated with mortgage rates. As the chart shows, and as you would expect, refinancing activity spikes when rates are low.
Refinancing your mortgage can be a way to be opportunistic and maybe save yourself thousands of dollars in the long run. However, refinancing isn’t always a good decision. So, when does it make sense to refinance, and when doesn’t it make sense? There are many factors to consider.
How long do you plan to be in your current home?
The number one factor to consider when refinancing is how long you plan to be in your current home. While some other factors might seem more important (like the rate), most of them are just part of the breakeven equation – the equation that shows how long you need to stay in your home to make refinancing worth the cost. For example, if you can refinance your rate from 6.0% to 3.0%, it doesn’t really matter if you plan to move next month! This is because there are costs to refinancing. You pay at least a portion of those costs up-front, so the day you refinance, you’re behind. Then over time, with a lower interest rate, you’ll recover some of those costs and eventually break even. Depending on a lot of different factors, you might recover those costs as quickly as less than a year, or maybe never!
How much does it cost to refinance?
There are a few different types of costs to refinancing. Some fees are paid to the lender, which reimburse the bank for the time it takes to work on your refinance. There may be other fees like an appraisal fee, documentation fees, etc. Refinancing a mortgage is a complex transaction that involves a lot of parties. They’re all looking to get paid, and chances are you’re the person paying.
Another notable expense is points. Points are basically prepaid interest. You pay interest up-front in the form of points, which effectively “buys” you a lower interest rate on the mortgage. Points are an interesting factor to consider. If you plan to be in your home for a long time, points might actually work out to your advantage. When you pay points, that will usually lengthen your breakeven time horizon, i.e. it will take longer for you to recover the costs of refinancing. However, you get a lower rate, and if you stay in your home a long time, you get to enjoy that lower rate longer. If you are fairly certain you will stay in your home for say, 10 years, and you conduct a side-by-side comparison of a loan without points and a loan with points, don’t be surprised if you come out ahead by paying points. Here’s a calculator you can use to help you determine whether paying points makes sense.
One expense that often goes uncalculated is the opportunity cost of up-front mortgage expenses. Opportunity cost comes in the form of lost interest or investment earnings. Let’s say you have to pay $1,500 in closing costs on your mortgage, and it will take you 2.5 years to recover that $1,500 by refinancing at a lower rate. What could you have done with that $1,500 instead of paying it to a bank to refinance? If we’re just talking about things that earn you money (and ignoring things like taking a weekend road trip or buying a new TV), you could invest that $1,500, keep it in an interest-bearing savings account, or pay down other debt like a car loan or student loan. Depending on the interest rates on those loans or deposit accounts, and the expected earnings in an investment account, that $1,500 of closing costs will actually be worth more than $1,500, which effectively lengthens the breakeven time period.
The last cost I’ll mention is another opportunity cost that comes from refinancing from a 30 year to a 15 year mortgage. If you refinance and your monthly payment increases because you’re shortening the term, there’s an opportunity cost that comes from paying more towards a mortgage instead of towards something else. In my own personal experience, opportunity cost made a big difference. My wife and I had a mortgage that originated seven years ago. We were considering refinancing to reduce our rate by 0.75%, and to accelerate the payoff by about eight years. When looking at the interest savings and breakeven point, it seemed like a complete no-brainer. My back-of-the-napkin math showed we would save about $20,000 in interest of the life of the loan, and it would only take us about 18 months to recoup the closing costs with a lower rate. But what about the fact that our payment was increasing by about $175? What could we do with that $175 for the next 15 years? We had been talking about putting some money aside each month in an investment account to pay for moving to a new home someday. We didn’t know if that would be 5 years from now or 20 years from now, but we thought it would be wise. So, if we weren’t refinancing, that $175 would have gone in an investment account in a moderately aggressive portfolio, and projected to return about 5.5% each year.
When I did the math, my conclusion was a bit surprising. Yes, refinancing the mortgage would save us $20,000 of interest, but because of the opportunity cost, refinancing our mortgage is only projected to increase our net worth by a total of $1,743.50. Over 15 years, that’s almost nothing! It’s basically a wash. We still did it, because at the end of the 15 years, we’ll have more free cash flow to invest than if we kept the 30-year loan, and because the math still works in favor of refinancing even if the amount is low. But the reason I’m pointing this out is that the opportunity cost cannot be ignored!
How much will your interest rate change if you refinance?
The bigger the interest rate savings, the quicker you recover your closing costs. This concept is relatively straightforward. Right now, your interest savings might be significant, because rates are at historic lows. The chart below shows that rates have been on a bumpy yet downward trend for the past 30 years. The most recent data point shows the average rate on a 30-year mortgage was 3.1% as of June 18th, which is well below the 10-year average of 4.1%. Saving 1.00% on a mortgage can mean significant savings if you plan to be in your house for longer than just a few years, and it shouldn’t take very long to make up those closing costs.
Calculate the breakeven point
Once you know the costs and the benefits of refinancing, do the math. Do the math? That’s not that helpful, is it? Well, it’s pretty complicated and easy to screw up. The spreadsheet I made has 17 columns and 191 rows. One of the formulas I used has 160 characters. So, you could either do the math, or you could just use a breakeven calculator that does that math for you. This one published by Bank Rate is fairly comprehensive. I have two criticisms, though. It doesn’t calculate opportunity cost, which we’ve said can be a major factor. Second, it considers tax savings on mortgage interest as part of the equation. After the tax law changes, very few people actually get a tax benefit from paying mortgage interest. According to the Tax Foundation, only 13.7% of taxpayers are projected to itemize their 2019 taxes. If you don’t itemize, just input “0%” in that Bank Rate breakeven calculator. That might not get you a perfect result, but it will be close.
Consider the nonmonetary factors
Once you know the monetary cost and benefits of refinancing, consider the nonmonetary factors, and ask yourself if it’s really worth it. I told you that refinancing our mortgage from a 30 year to a 15 year mortgage was only projected to increase our net worth by less than $2,000 in the long run. But refinancing also took time from both me and my wife when we consider signing documents, meeting with a loan officer, budgeting for the closing costs, coordinating escrow refunds, shopping for new homeowner’s insurance (not required, but a good time to reconsider), and now writing a blog post about it. Was it really worth it for less than $2,000? For us, yes. We like the idea of having a mortgage paid off in 15 years. There are intangible benefits to paying off debt, like peace of mind and flexibility. I think sometimes people can go overboard with certain things like paying off all of their debt as early as possible (I did say I don’t agree with Dave Ramsey all of the time), but some things just can’t be captured with math.
Is it worth it for you to refinance? Try using that refinance calculator to shed some light. If you want a thinking partner to help you through the nonmonetary parts of the decision, or if you want someone to guide you in the direction of what a professional financial planner might believe is best for someone in your shoes, schedule an introductory meeting with us. We’d love to help clarify this decision – and many other financial planning decisions – for you.