At least once per year I get the itch to refinance our mortgage. I spend an afternoon researching and running the numbers but I’ve never actually pulled the trigger. Why? I just can’t justify the closing costs and the interest rates haven’t been that much lower than what we are currently paying. But here I am once again on a mission to find us a new mortgage. I thought I’d share my process with you.
So that we can use real numbers in our discussion I’m going to make up a mortgage for us to consider. $150,000 loan at 5.5% with a 30 year fixed rate. Our pretend family has been paying on their mortgage for 5 years, therefore has 25 years left to pay. In this case they haven’t been paying extra, but we will talk about that too.
Here’s what you need to consider when refinancing:
The Term Of The Mortgage
The term is the length of the mortgage. How many years your payments will last. I caution you against refinancing with the primary goal of lowering your payment. The only way to make a significant impact on your payment is to stretch the term of the loan out, which will leave you paying tens of thousands, in additional interest. It probably also means you will be making a mortgage payment in retirement which will impact your quality of life at that time. So it’s not something to do unless you are in crisis mode .
Often times, the lure of a lower payments traps people into a longer term. Unless you are having significant trouble making your mortgage payment I would try to avoid too much of a lower payment. If you are looking at a huge drop in payment make sure you understand what the new term is. Ask yourself, do you really want to make a mortgage payment for another 30 years? How old will you be then? What lifestyle do you want to have? Does a mortgage fit into that lifestyle?
The goal of refinancing is to get the house paid off and pay as little interest as possible. Extending the length of the loan does neither of those things.
The Monthly Payment
Of course, while refinancing your new payment is going to be something to consider. For my own purposes I’m looking to keep my mortgage payment the same. Each situation is different though, maybe you can afford a bigger payment if your career has taken off since you bought your home (yay!). I’d be willing to make a higher payment for a shorter term.
If your payment is actually going to be less than before consider continuing to make your old payment. This will reduce the total amount of interest you will pay and shorten the term.
The Interest Rate
Obviously, you want a lower interest rate than you are paying on your existing mortgage. If you can’t get a lower rate on your refinanced mortgage then it’s not even worth
discussing. The rule of thumb is to reduce your rate at least 1% to really make a difference.
Closing costs can be significant and many people don’t even consider them when deciding to refinance. Make sure you know what the costs are going to be when you’re going in and include them in your calculations. You always have the option of just paying those closing costs straight to the principal of your current mortgage. That will also reduce your term and interest paid. So think about that. If you are going to pay $5,000 for your new mortgage, consider the impact of that $5,000 on the mortgage you already have. It might not make sense to refi.
Paying “points” on a mortgage is basically pre-paying some of your interest. Each point you pay brings your interest rate down by .125%. You will pay $1,000 per point for every $100,000 of mortgage. So our fictional family would pay $1,500 to reduce their rate by .125%. You have to run the numbers of your particular situation to see if this is worth doing. When doing the calculations consider possibly paying that $1,500 to your mortgage balance instead. I have a detailed post over at Enemy of Debt about points if you want more information.
Some Different Options
Let’s look again at our fictional family. We also need to know their goals. Has their situation changed and now they need a lower payment to make ends meet? Do they want to lower their interest rate? Do they want to get the house paid off as soon as possible?
Our pretend family has listed lowering their interest rate as their primary goal. If they can shorten the term that’s great, and if they end up with a lower payment then that’s fine too. However they are not willing to increase their payment.
As a reminder here is the current stats for their mortgage. They are currently paying $922.66 per month and have 25 years left to pay. If no changes are made to their mortgage they will pay another $126,339.37 in interest.
Financially, the best deal of the group is the 15 year mortgage at 3%. If they pick this option they will save almost $90,000 in interest and cut 10 years off their current mortgage. That’s amazing! However, they will increase their payment by just over $100 per month and have to cough up over $5,000 at closing. Can they do that? If they are comfortable with a slightly higher payment but can’t manage the closing costs they could go with the 15 year, 3.875% mortgage and still save almost $80,000 and be mortgage free 10 years earlier.
If they can’t swing either extra cost then their next best bet is probably the 20 year mortgage at 4.25%. They would save over $53,000 in interest and cut 5 years off the length of their mortgage. Their out-of-pocket would be about $1,500 and their payment would only be $6 more per month.