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.
Just a comment on the escrow. It’s easy to just “set and forget” this, and not shop around for insurance or look for ways to reduce your property taxes (such as applying for the so-called “homestead exemption” here in Florida). But this can save you lots of cash.
For example, last year we did a major home remodel that made it more hurricane-resistant, which reduced our insurance premiums by a few thousand dollars. Because of this, our escrow payment (and therefore our monthly mortgage payment) came down by over $100 per month.
I’ll go a step further and point out the fact that in some cases, your lender may waive the requirement to escrow, if you ask. An escrow account is non-interest bearing. You could save that amount of money in an interest-bearing account and make the property tax and insurance payments yourself. In some cases (certain types of loans and loans where you have a fairly small amount of equity), the escrow requirement won’t be waived.
Definitely look at any exemptions that would help lower your property taxes. In my state, for example, there are exemptions for the homestead exemption as well as for low-income senior citizens, military, and one-room schoolhouses (I’m completely serious) and many more.
You can also appeal the tax assessment on your house if you feel that it’s not reasonable. We recently had assessments done in our neighborhood. Some of the neighbors talked about appealing their assessments. We didn’t bother, because we looked at the recent history of comparable home sales in the neighborhood (good growth) and agreed that the assessment was fair.
Shopping around for insurance is always a good idea, and refi time is as good a time as any.
If you’re looking to do house upgrade that will lower your insurance costs, it’s likely that your agent would love to sit down with you and give you tips on things that could lower your coverage. Everybody wins when your house doesn’t burn to the ground.
That’s a great point Miguel. I was trying to think if there’s any way we can reduce our insurance or property taxes and I don’t see an easy way.
I’m not a huge fan of shopping around for insurance simply because it seems difficult to compare coverage. It’s also helpful that we have USAA which is usually very good with all its financial products.
Lower your *premium*, not lower your coverage.
A couple of comments. First, I really like handling my own escrow. The Dallas area is a booming real-estate market so I can adjust my the amount I’m saving for property taxes(in a separate savings account) and not get caught short by some less than observant escrow manager.
I’m always uncertain about refinancing(and that’s not good given that I’m not young and have refinanced several times in my life, the first time to get the interest from like 14 to 12%). Our current mortgage is a 30 year(with about 24 years left) at 4.375%. Our principle/interest payment is pretty low. I considered the refi, but it seems I’m permanently in an questionable job situation(though I hit 25 years in that uncertain job this year). So I found some prepayment calculators, and I started making the payments to pay off my mortgage in 15 years(actually less). That saves me the cost of the refi, and then allows me to drop back to the much lower payment should the job actually go away for awhile. Good idea? Bad idea?
It really depends on how much you value that safety net.
Let’s say you have a remaining balance of $150,000 on your loan. You’re at 4.375% with 288 months (24 years) remaining:
That would mean:
P&I: 842/month
total payments: 242,534
If you make extra principal payments and pay it off in 15 years instead of 24 (essentially making it a 15 year mortgage at 4.375%), you’ll have
P&I: 1138/month
total payments: 204,827
If you refi to a 15 year at 3.25% (this is possible – we got 3.125), you’ll have:
P&I: 1054
Total payments: 189,721
So you’ll save about 38K by making extra principal payments to shorten it to 15 years, and about 53k (minus ref costs) to refi into a 15 year at 3.25%. So you do get a big portion of the savings simple by making the larger payments.
The idea of good or bad idea can be a difficult one because it involves assessing someone else’s risk tolerance and their financial situation.
I personally love the lower interest and shorter term to own the home, but it means making sacrifices in other financial areas of our lives. It can be tough to thread that needle sometimes. It really depends on your overall financial situation.
I prefer to go with the 15-year refinance myself and try to gut that out anyway possible. If it gets really bad, you can always refi back to a 30-year. I don’t have the exact numbers like Kosmo, but if you pull off 5 years at 15-year fixed and only have 10 years left, you’ll have paid off a lot of principle. If that bad time comes around and you have to finance back to a 30-year, your payments will be much smaller than they are now because:
1) You cut down on the principle with the 15-year
2) You are now spreading that new lower principle across 30-years, restarting the loan.
That’s not a great option if you are older, but you might find that the payments are around $500 (using Kosmo’s example)
To expand on Lazy Man’s suggestion of going to a 15 year, paying on it for 5 years, and then doing a refi to a longer loan if needed.
After 5 years of paying on the 15 year, you’d be left with about 107,000 of remaining principal. If you were refi that balance into another 15 year loan (giving you a payoff date of 2037) at the same rate of 3.25%, your P&I payments would drop to $752 between 2022 and 2037 – $90 *less* than your current payment. Your total payments from now until payoff would be about $200,000.
Basically, any of the alternatives would be significantly better than simply making your required monthly payment on the existing mortgage.
In my own situation, I was taking advantage of an inheritance to pay the mortgage balance down to the point where we could refi to a 15 with basically no impact to the monthly budget. Obviously, that’s not an option for everyone. But if you do have that sort of a situation, consider using the money in this way instead of buying a shiny new car. Your future self with thank you.