We are in the process of refinancing our mortgage – again.  We bought our first home in 2005.  Due mostly to the expense and uncertainly of kids, we took out a thirty year mortgage.  In 2014, we moved to a different, larger house with a different, larger mortgage.  My mom’s estate was recently settled, and we decided to pay down the principal refi the 30 year mortgage (which has 27 years remaining) into a fifteen year mortgage at roughly the same cost (about $15/month more).

[Editor’s Note: I wanted to emphasize that again… he reduced 27 years of paying a mortgage to 15 years!]

While the optimal choice for us would have been to start with a 15 year mortgage, this really wasn’t feasible at the time.  We wanted to be able to fund retirement plans, 529 plans for the kids, pay for day care (a big cost, especially before the kids reached school age), have a sufficient emergency fund, and have the flexibility to deal with other costs that popped up along the way.

One thing we did do over the years is refinance.  In the nine years that we owned the first home, we refinanced it twice.  In each case, the break-even point was between eighteen and twenty-two months.  After each refi, we continued to pay the amount of the original mortgage, but with additional money going to principal (shortening the length of the loan).  A key part of understanding the break-even is understanding what portion of closing costs are actual incremental costs and which are not.

Pre-paying the escrow is money that you pay to ensure that there is a enough money in your escrow account to pay for homeowner’s insurance and property taxes.  Why is this not an additional cost?  Because you’re spending money up front to fund the escrow on the new mortgage, but you’ll be getting a check for the amount that is in the escrow account for your old mortgage (this may take a month or two, depending on your state and your lender).  Regardless of whether you kept the old mortgage or refinanced, you would have had to had sufficient funds in the escrow account to cover the taxes and insurance when they are due.  Once the escrow on the old mortgage is refunded, it’s a wash.

You’ll also have some pre-paid interest.  This accounts for the interest in the partial month between your closing date and the first of the month.  If you close on the 30th, this cost will be minimal.  If you close on the second, it would be almost an entire month’s worth of interest.  But this is interest you would have paid regardless if you refinanced or not.  It’s important to note, though, that if you close on the 2nd, you’re skipping an entire month’s worth of principal payments, pushing your payoff date nearly a month past what it would be if you had closed on the 30th.

What remains are the actual incremental costs to refinance.  In my specific case, these come to around $1500.  To illustrate the break-even calculation, let’s assuming you are saving 3/4 of a percent and have a mortgage balance of $150,000.

• The monthly interest savings would be (180,00/12)*0.0075 = $112.50
• Here’s the tricky part.  While mortgage interest is tax deductible, the closing costs generally aren’t.  Let’s assume your combined federal and state income tax rate is 25% (note: you’ll want to use your marginal rates, rather than your effective rates, since you’re calculating an incremental effect).  This means the actual cash savings from the reduced interest is ($112.50 * 0.75) = $84.375.
• $1500 / 84.375 = 17.77 months

While this is a reasonably accurate quick calculation, it will be slightly off, because you’re saving slightly less in interest every month.  You’ll save $112.50 ($84.375 after adjusting for impact of taxes), in month one, but you’ll save a dollar or two less in each additional months.  So to be safe, just round-up and add another month to the break-even length, bringing the break-even to 19 months.

Some other notes about mortgages and refinancing:

• Some people have a rule to not refi within X years of taking out the mortgage or doing a previous refi.  This is not a good determiner of whether the time is right to do a refi.  If you close on a mortgage today and rates drop a full point tomorrow, you absolutely should refi.  You can’t change the fact that you had bad luck in the past – but you can change your future rate.  The key thing to look at is how many months it will take to break even on the refi costs.
• When buying a house, some people will approach the lender and ask what amount they can be pre-approved for.  My advice is instead to settle on a price point and get pre-approved for that amount, plus a small cushion.  If you ask the lender to set the amount, odds are good that it will be higher than the price point you would have chosen, and you may end up purchasing a more expensive house than you really need.
• A lender will often allow – or even encourage – you to roll the closing costs into the mortgage amount.  If you have the ability to pay these amounts up front, it can save you quite a bit of money in interest.  We’ve never rolled the closing costs into a mortgage or refi.
• Shop around.  You may be able to find slight differences in rates between lenders.
• Watch for coupons.  We routinely get coupons in the mail for $100 off closing costs.  When we knew the a refi would be imminent, I made sure to save one of the coupons.  In comparison to the mortgage, $100 is a very small amount – but it’s still $100.