The are a bunch of costs that go into refinancing, which unfortunately eat into the savings of refinancing. The way to think about costs is to get the total cost of refinancing divided by the monthly savings of refinancing to see how many months it takes to break even.
For example, let’s say it costs $3,000 to refinance a $400,000 loan from 5.25% to 4.25%. Your monthly payment goes from $2,375 down to $2,135 for a savings of $240. Take the $3,000 in refinancing costs divided by $240 = 12.5. In other words, it takes 12.5 months for your cash flow to start benefiting from a refinance.
If you plan to take 360 months (30 yr fixed) to pay off your mortgage, your actual savings would be $83,400 (347 months X $240) making the $3,000 cost to refinance a no-brainer. Ironically, you save less if you pay off your loan quicker from a refinancing stand point. From a bank’s point of view, this is called “prepayment risk.” They don’t want you to pre-pay because they want to make as much money from you for as long as possible.
Savvy readers will realize that there’s a difference in cash flow savings vs. interest savings. Even though my $1 million mortgage refinance will drop down to a $3,882 a month payment from $4,338, the $456 a month savings is not all interest savings because I’ll be paying less principal as well.
The easiest way to calculate the interest savings is to take the mortgage amount and multiply it by the difference between the interest rates e.g. $1,000,000 X (2.625% – 2.25%) = $3,750. Now take the cost of refinance and divide it by the interest savings to calculate a truer break even number.
You can also ask your mortgage officer what the cost would be to refinance at a higher rate. In this example, you could get a “credit” to your costs if you refinanced for 4.75% instead of 4.25%, thereby having less money leave your pocket.
The general rule of thumb is that if you plan to stay in your house for over 5 years, and it costs no more than 20 months until you break even, you should refinance. I personally shoot for a break even cost of less than 12 months.
The Pain To Refinance Factor
It would be nice if one could just snap one’s fingers and change the terms of a loan. Unfortunately, it’s not that simple and you need to spend at least five hours of your time speaking to your mortgage representative and preparing and signing the paperwork.
Further, the whole mortgage refinance process could take more than three months, as was the case with my previous mortgage refinance. A good agent should be able to tell you all the necessary documents you need to get things going.
The mortgage process generally takes about a month and a half given the bank needs to pay off the loan, send an appraiser to figure out the loan-to-value ratio, check your income and assets, go through the title company to get the proper documents, pull insurance records from the homeowner’s association, and get you to sign everything. It’s the underwriter who is going to give you the hardest time, so be prepared for battle.
The less you make, and the less busy you are, the more you should look into refinancing! If on the other hand, you’re happy with your loan, don’t have a lot of time, and make a ton of money, your time is worth more than the headache you will go through to save $16,000 bucks in the example above.
THINK LIKE AN INVESTOR
A lot of people think that all debt is bad. These are probably the same people who haven’t been able to successfully leverage debt to build their net worth as much as they could. I do believe that too much debt is bad. The banks have determined that having a debt-to-income ratio of over 42% will not qualify one to refinance or get a loan.
As an investor or CEO, one of your goals is to utilize the right mix of debt and equity to provide the highest return on equity possible. The key is to not take on too much of either to avoid risk of insolvency. When interest rates are low, borrowing money becomes cheaper than raising money through equity. When interest rates are high and equity valuations are low, the reverse is true.
If you are a mortgage borrower, then you actually want inflation to come back. Inflation means your underlying assets – in this case your home – is inflating at a higher rate than before.
You want inflation as an asset owner. Meanwhile, inflation will pull interest rates higher, making your mortgage that much more valuable to HOLD. If you paid off your 2.75% mortgage and decide you want to borrow money again in an interest rate environment that’s now at 5%, you’re hurting.