The purpose of this article is to give consumers a guide for determining whether or not a proposed refinance makes financial sense for them. Through my interactions with many of my clients over the years I’ve found that much of the population is left confused when evaluating mortgage refinance options. I hope that I can shed some light through this article so that you can make better decisions about your own situation.
Because evaluating proposed refinance options is often confusing and overwhelming, many “rules” have been created over the years in an attempt to simplify the formula. Among the most common of these is the “1% rule” in which loan holders are to refinance ONLY if they can lock a rate 1% below their existing mortgage rate. Although I applaud the simplicity of such a rule I do not think it is effective in helping people make wise financial decisions.
The truth of the matter is that every single household’s situation is different and therefore there is no blanket rule that can apply to all people. We may advise two households differently even though they have the exact same mortgage balance and the exact same interest rate evaluating the exact same refinance proposals because each has different objectives.
So how do you decide whether or not a proposed refinance makes sense for you? Here is a methodology that we use with our clients:
The first step is to identify what your objectives are.
For most people the biggest consideration in deciding whether or not to refinance is cost. If they can replace their existing loan with a lower cost option then the refinance makes sense for them. For these people we’d like to remind them that costs can be expressed in a variety of ways such as closing costs, interest costs, opportunity costs, etc.
For other people the monthly payment or loan program may be their biggest consideration. For example, maybe someone is anticipating going back to school and wants to refinance into an interest-only loan to reduce their monthly payments. Or, maybe a person has an adjustable rate mortgage (ARM) that is scheduled to adjust in the coming months and they think that it would be a good time to lock in a fixed rate. These considerations may not be motivated by cost in the near term but instead by lifestyle changes.
The bottom line is that the objectives can vary depending on the person and the circumstance. It’s important that a person identifies what is important to them and communicates it to their mortgage professional.
The second step is to evaluate your options.
Once your mortgage professional understands what you’re after, they should be able to provide you with multiple refinance options based on those objectives. This is where the art of evaluation comes into play.
At the heart of evaluating a refinance proposal is a cost-benefit analysis. As a consumer you must weigh the cost associated with the refinance (as measured by the closing costs) against the proposed benefit (your objectives).
If your objective is anything other than cost the evaluation is much more subjective in nature. You will have decide if the closing costs you’ll incur for refinancing is worth whatever benefit you are seeking.
If cost is of most importance, then the cost-benefit analysis is relatively easy to complete. With this analysis we’ll evaluate the proposed cost of the refinance, in terms of closing costs, and weigh it against the proposed interest savings over time.
The cost-benefit analysis looks like this:
Proposed closing costs ($)/ Proposed Interest Savings ($ per month) = break even period: # of months in which it would take to recoup the closing costs and begin saving money
Once a person has calculated the length of time it would take for them to recoup their closing costs they can then decide if they expect to hold the loan long enough in order to experience significant savings.
In order to make sense of this concept lets evaluate a hypothetical situation:
Johnny Homeowner bought his home in January of 2006. At that time he took out a 30 year fixed rate mortgage @ 6.50% which he’s made standard payments on ever since. As of March of 2008 his loan balance is $296,067 and his monthly principal and interest (P & I) payment is $1,871.
He is currently evaluating a refinance proposal which would replace his existing mortgage with a new 30 year fixed rate mortgage @ 5.875%. The closing costs associated with the refinance are $3,000 which he has decided to include in the new loan so that he doesn’t have to pay them out of pocket. The new monthly payment would be $1,769 which represents a savings of $102.
Here is the analysis for him:
$3,000 (closing costs) / $102 (monthly interest savings)= 29 months.
What the analysis suggests is that he would have to maintain this mortgage for 29 months in order to recoup the initial closing costs he paid for the refinance. From that point forward he’s in better shape than he would have been had he not refinanced. So, for him to evaluate whether or not this makes sense he’d probably want to feel confident in the fact that he’ll have this loan for at least 30 more months.
The last step is to make your decision.
Since everyone is different there is no right or wrong answer when it comes to refinancing. We can help you best understand the implications of refinancing but ultimately it’s up to you to decide whether or not you should do so.
Typically we try to provide our clients with little to no closing cost refinance options because we believe there is less risk of making a bad decision when the break-even period is relatively soon. The tradeoff in that the borrower may not be locking an interest rate that is as low as they could get if they were willing to incur more costs.
If you decide that the refinance terms are not good enough to justify the cost then be sure and communicate that to your mortgage professional. Often times they can keep a lookout for you so that if/ when the opportunity does present itself they can pro-actively let you know.
In summary, deciding whether or not to refinance can be a difficult decision. In order to make sense out of it we’d first encourage you to identify what your motivation for refinancing is. Second, communicate that to your mortgage professional and have them work up some options for you to review. Evaluate these options using a cost-benefit analysis to decide whether or not the proposed benefit outweighs the cost of the loan. Finally, remember that there is no right or wrong answer. If you think that it makes sense then go for it and if not be sure to inform your mortgage professional what it is you’re looking for so that they can keep an eye out for you.