Friday, June 4, 2010

Thinking of Refinancing? Better Read This First

With mortgage rates at historic lows, we’ve been looking into refinancing our home loan. We have 24 years left on a 30-year fixed rate mortgage at 5.625%. I called Wells Fargo and for what’s called a super conforming loan, we can refinance down to 5% for 30 years. So should I refinance or not?

The answer to that question generally involves calculating how much you’ll save each month if you refinance your mortgage. With the monthly savings in hand, you can then divide that number into the cost of refinancing to determine how many months it will take you to recoup the cost. If you plan to stay in your home at least that long, then refinancing is worth the cost.

There are two big problems with this analysis, which we’ll cover in a minute. But first, let’s look at an example. We’ll assume that we took out a 30-year fixed rate home loan 6 years ago in the principal amount of $250,000. We’ll also assume that we can refinance down to 5% for 30 years with total closing costs (excluding prepaid items like insurance and taxes) of $4,000. Using my favorite mortgage calculator, we can determine the following about the loan payments under the original mortgage, the current balance, and the loan payments if we refinance (numbers are approximate):

Original Principal & Interest Monthly Payment: $1,500
Principal balance after 6 years: $228,500
New Principal & Internet Monthly Payment: $1,250 (assumes we refinance the remaining balance on the mortgage plus the closing costs).
Monthly Savings: $250
Time to Recoup Costs: 16 months ($4,000 / $250)

At first glance, if you plan to stay in the home at least 16 months, refinancing would seem like the right choice. There are, however, two problems with this analysis: Taxes and Time.
Tax Consequences of Refinancing

Because mortgage interest is deductible from state and federal income tax, we must factor in the affect of refinancing on our tax liability. Of course, if you do not itemize your taxes, and therefore do not take advantage of the mortgage interest deduction, then you don’t need to worry about this adjustment. But for those that do itemize, you should adjust your monthly savings for the increased tax liability that will result from paying less interest.

Given a current balance of $228,500, we know that in year seven of our current mortgage we would pay approximately $13,500 in interest. Under the refinance, the interest payments would drop to $11,500 ($232,500 x 5%) in the first year of the loan. Thus, the refi would result in our paying $2,000 less in interest during the first year of the new mortgage. Assuming a combined state and federal marginal tax rate of 25% (your tax bracket may vary, of course), we can estimate that our tax liability will go up $500 in year one as a result of the refinance.

Thus, our monthly savings initially calculated as $250 a month decreases to about $210 per month. And that results in the time to recoup our closing costs moving from 16 months as originally calculated to 19 months. Maybe not a deal-breaker, although it could be with larger mortgages or higher tax brackets. Either way, it’s important to consider taxes when deciding whether to refinance a mortgage.
Effect of Extending Term of Loan

Having looked at the tax consequences of refinancing, we now need to look at the affect of extending our current mortgage balance out over 30 years. Recall that under the existing mortgage, we only have 24 years left on the loan. As a result, some of our reduced monthly payment comes not from interest savings, but rather from lower principal payments because of the longer term.

While this may come as a shock, under the refinance scenario above, you would actually pay more in total interest under the refi than you would just sticking with your original loan. That may seem counter-intuitive given that the interest rate is going down by 1%, but extending the loan back over 30 years results in more interest payments. Let’s do a quick comparison:
Original Mortgage
(24 years remaining) Refinance to 5% and extend term to 30 Years Refinance to 5% but keep term to 24 Years
Current Balance (excluding closing costs of refinance) $228,500 $228,500 $228,500
Interest Rate 6% 5% 5%
Total Interest paid over life of loan $203,000 $213,000 $164,000

Notice that although we lower the interest rate to 5%, our total interest payments go up when the loan is extended back over 30 years. Now this doesn’t mean that refinancing to 5% for 30 years is a bad decision. But it does mean that you should consider your options, which include the following:

* Refinance to 30 years to benefit from lower payments, but recognize that the total interest you pay will be more than if you didn’t refinance at all.
* Refinance to 30 years, but pay extra on the monthly mortgage so that you’ll pay the loan off in 24 years. You’ll still have a monthly payment less than your current home loan, and you won’t pay the extra interest.

The key here is to make an informed decision about refinancing your mortgage. Recognize that factors beyond the interest rate will affect how your monthly payment will change (taxes and term). Also, the above analysis assumes that you are refinancing from one fixed loan to another. You may want to refinance to get out of a variable rate loan, which is often a wise decision. Either way, don’t let the current mortgage rates pass you by if refinancing your mortgage could help save you money.


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