You've probably found yourself at one time or another wondering whether it was a good time or not to refinance the house. You figure you can consolidate some bills, free up some monthly cash, maybe take some cash out...you know...to fix up the house...possibly get that new flat screen TV you've been talking about...and then maybe take a vacation with what's left. Sounds good. It helps the economy, and hopefully it helps you too.
Like many people, you have probably heard of, or hold to, a rule of thumb regarding when to refinance that appears to have served others, or even yourself, well. I say "appears" precisely because things are not always what they appear to be. And when it comes to when to refinance rules of thumb, you must beware of simplistic rules. A refinance is likely the LARGEST financial transaction you may ever make and two of the most widely used rules of thumb don't consider the big picture. Simple is great, except when it's SIMPLY WRONG.
When To Refinance Rule Of Thumb Myth #1
So what are these two when to refinance rule of thumb myths, and how is it they can appear to be giving you a good deal, while in many cases actually costing you thousands? Well the first myth is what many people call the 2% Rule. This rule states that you should never refinance into a mortgage that doesn't reduce your interest rate by at least 2%. And if you can refinance into a mortgage with a 2% or greater decrease in interest rate, then the monthly savings will add up to long term savings over the life of the new loan. In some cases this can be true and in many others it is not. The problem with this rule, as you will see shortly, is that it is blind to all other loan factors besides rate. Let's take a look at some actual figures and put this rule to the test.
(Note: The figures and calculations below will be explained for those of you that want to learn to calculate refinance costs yourself, as well as for those of you that may not trust my math...LOL. I apologize if I get too detailed, but I really want YOU to know for YOURSELF if you're saving money, rather than relying on a salesman's opinion. This is information EVERYONE MUST HAVE. As you read this article you will learn how to save thousands in the refinance market, so it's well worth your time to read each section all the way to the end. Also please note that the Mortgage Payment Calculator mentioned below can be found by following the link found at the end of this article. It is not needed to follow along with this article, unless you wish to double-check the calculations.)
For our example, let's assume 15 years ago you took out a fixed rate home mortgage for $195,000 at 8% for 30 years. Your CURRENT balance on the loan is $149,720.90. You have 15 years left to go and the payment on this mortgage is $1,430.85 per month. If you input these figures into my Mortgage Payment Calculator you'll see that the TOTAL amount of money you will pay in principal and interest over the life of this loan is $515,092.47. (This total cost is disclosed to you on a lender's Truth-in-Lending Statement (TIL), and by law this statement must be provided to you by the lender within 3 business days of application.)
Over 15 years you've made 180 payments of $1,430.85 for a total of $257,553.00 already paid. If we subtract what you've already paid from the total obligation of $515,092.47 we find that you still owe $257,539.47 for the final 15 years. This number serves as a good starting point for comparing different loan offers, because you should have your Truth-in-Lending (TIL) Statement early (within 3 days) and it will instantly show if the new loan is substantially more costly than your current mortgage. But this is NOT the final word as there are other considerations that vastly affect cost and savings. We'll get to that shortly, but first let's continue with our example.
A lender has offered you a $150,000 fixed rate mortgage at 6% for 30 years with 2 discount points down and $2500 in closing and processing fees. (A single discount point is equal to 1% of the loan amount.) Like many people you may decide to finance the points and fees into the loan. For this example we will finance these costs, so our total NEW loan amount will actually be $155,500, but still at 6% and still for 30 years, and your monthly payment will be $932.31. Using either my Mortgage Payment Calculator or your TIL we can see that the total cost of this new loan is $335,622.63.
So is this refinance going to save you money? It does follow the 2% Rule. The lower payment is also SAVING you $498.54 every month, but the TIL shows it COSTS $78,083.16 more to take this loan. So what's the deal? Will this loan save you money, or cost you money? The correct answer is...IT DEPENDS.
As it happens, one of the most determinate factors affecting your wallet in a refinance is TIME. And I don't just mean the number of years on your mortgage term. Regarding our example above, I specifically mean the length of time you plan on keeping your home or mortgage. This is one of those factors that the 2% Rule fails to consider. So why is that so important? It's because any savings or costs in a refinance are realized over TIME. The bottom line is constantly changing as time progresses, you could be saving more and more, or losing more and more.
It is true that the above refinance would cost you $78,083.16, but that's only after 30 years. However, after only five years, taking the refinance has actually SAVED you $3,140.18. If you moved or paid off your mortgage after five years you'd be ahead of the game. At 10 years you'd still be ahead by $253.16, at 15 years you've lost $20,741.16 and at 20 years you've lost $50,172.85. I'm sure you can see the downward trend as time moves on. The monthly payment savings has the most benefit early on in the loan, while the slower decline of the principal balance progressively nullifies that benefit as time goes forward. The impact is substantial, yet the 2% Rule doesn't consider either of these two factors.
Let's give the 2% Rule another test run as a when to refinance rule of thumb. We'll use the same scenario as above, but we'll make it a debt consolidation refinance that you're considering. This refinance will pay off $20,000 in credit card and other consumer debt, freeing up the $250 you had been sending in for monthly payments. So in this case the loan amount will be $175,900. We're still financing the 2 points and closing fees and the rate is still 6%. But now let's make the TERM for 15 years. This shorter term makes the monthly payment $1,484.35 which is actually in increase of $53.50 over your present payment, but when combined with the debt consolidation savings of $250, nets you a TOTAL monthly savings of $196.50 every month. Using either my Mortgage Payment Calculator or the TIL you will see the total cost of this loan is $267,181.30. Subtracting this from the $257,539.47 we know you still owe on your current mortgage results in a LOSS of $9,641.83, after 15 years, IF you take this refinance.
But as I mentioned earlier, this is not the final word as there are other considerations. Like what? Well, like the $250 you're saving every month on those paid off debts. We still have to account for that. The Truth-in-Lending statement only shows costs related to mortgage payments and loan balances over time. Now since our CURRENT loan has 15 years left and our NEW loan is for 15 years, the loan balances would reach zero at the same time, so after 15 years the costs related to loan balances are the same. This means the only cost shown in our TIL comparison above comes from the change in monthly payment. That's why if you multiply the loss of $53.50 over 180 months (15 years) the resulting total loss of $9,630 is basically IDENTICAL to the loss of $9,641.83 shown in our TIL comparison. (While it's a negligible amount, the reason for the difference is that the FINAL payment on a loan is almost always lower than the NORMAL monthly payment, where our calculation assumes all 180 payments were the same.)
Now, back to accounting for the other consideration--the debt consolidation savings. When we multiply the monthly savings of $250 over 180 months, or 15 years, the resulting total is $45,000.00. When combined with the loss of $9,641.83 we find you've actually saved $35,358.17 after 15 years!
So the 2% Rule is in effect, and we can demonstrate some pretty substantial savings over the life of the loan. Does that mean that using the 2% Rule in this case will definitely save you money? Again...IT DEPENDS. If you moved or paid off this mortgage after five years you've actually lost $3,982.92.
This is because the difference in loan balances (what you would have to pay-off) is greater early in the loan. And the monthly payment savings can only show benefit once the steadily accelerating decline in the principal balance of the NEW loan has been given time to catch up to where the balance of the OLD loan would be at that time. (This will make more sense when I show you how to calculate this for yourself shortly.)
There is an upward trend in savings as time moves on, going from the negative, upward into the positive. So for this refinance to save you money, you must STAY in your mortgage until that trend line flips from the negative side of losses to the positive side of savings. But again, this information fails to be considered when using the 2% Rule as a when to refinance rule of thumb. Clearly, relying on the 2% Rule as a when to refinance rule of thumb is no guarantee of savings.
When To Refinance Rule Of Thumb Myth #2
I promised you two when to refinance rule of thumb myths and I won't disappoint. The second myth that could cost you thousands of dollars is what I will refer to as, for brevity's sake, the $200/month & 5 Year Rule. This rule states that if you can refinance into a mortgage that saves you at least $200 every month AND doesn't add more than five years to the remaining term on your current mortgage, then it will save you money in the long run. The problem with the $200/month & 5 Year Rule as a when to refinance rule of thumb is that, like the 2% Rule, it is blind to many of the same loan factors such as the impact of time and loan balances. But where the 2% Rule was blind to monthly savings, the $200/month & 5 Year Rule is instead blind to interest rate. Let's check out some actual figures and see if this rule fares any better than the 2% Rule.
In this example, let's assume 15 years ago you took out a fixed rate home mortgage for $211,000 at 6% for 30 years. Your CURRENT balance on the loan is $149,910.62. You have 15 years left to go and the payment on this mortgage is $1,265.06 per month. If you input these figures into my Mortgage Payment Calculator you'll see that the total amount of money you will pay in principal and interest over the life of this loan is $455,413.17. Over the last 15 years, the 180 payments of $1,265.06 you've made total $227,710.80. Subtract this from the total cost of $455,413.17 and we see you still owe $227,702.37 over the next 15 years. As before, this becomes our starting point for comparison.
The lender comes back with a debt consolidation loan offer in order to provide the $200 monthly savings. Again we'll assume you're paying off $20,000 in credit card and other consumer debt, which frees up $250 each month. So the offer is a fixed rate mortgage of $175,900 at 6% which includes the 2 discount points and closing fees which are being financed. In order to get the $200 monthly savings, it is necessary to extend the TERM to 20 years, and this makes your monthly payment $1,260.21. This is a monthly savings of $4.85 over your PRESENT payment and you're also saving $250 per month due to debt consolidation for a total savings of $254.85 each month. Using either my Mortgage Payment Calculator or your TIL we can see that the total cost of this NEW loan is $302,446.81 after 20 years. Subtracting this from the $227,702.37 we know you still owe on your CURRENT mortgage results in a loss of $74,744.43 after 20 years, IF you take this refinance.
But as you remember from our prior debt consolidation example, we still have to account for the $250 monthly savings over those 20 years as well. So 240 months, or 20 years, multiplied by $250 per month in savings equals $60,000. When we combine that with the loss of $74,744.43 from our TIL costs calculation, it results in a total loss of $14,744.43 after 20 years.
Well, so much for the $200/month & 5 Year Rule being bulletproof. What if you get out of the home or mortgage early in the term, do you come out ahead then? Sadly, no. In this scenario, the rule FAILS COMPLETELY. The loss after 20 years is the HIGHEST this trend line ever climbs. It is climbing, but climbing only halfway out of a hole still leaves you in the hole. After five years you've lost $20,103.16 and after 15 years you've lost $19,309.81.
In this scenario the $200/month & 5 Year Rule would cost you thousands no matter what you did. Like the 2% Rule, I know there are scenarios where this rule can be applied, and it will be financially beneficial, but blindly relying upon either of these rules as a when to refinance rule of thumb is a crap-shoot. How do you do when you're in Vegas? "Do you feel lucky...punk? Well DO ya...?"
The banks, like casinos, have all run their numbers. They know the statistics, they know the odds. If you're determined to come out on top, then you must RUN THE NUMBERS.
So as a when to refinance rule of thumb, do the 2% Rule or the $200/month & 5 Year Rule work? Sometimes Yes, and sometimes No. Do they capture all of the complexities related to refinance costs? Certainly not. Do they serve as reliable when to refinance rules of thumb to use as a basis for your next refinance decision? That's something only you can answer for yourself, but as for myself, I trust numbers and I am always going to DO THE MATH. To me, a rule that works sometimes is UNRELIABLE, and essentially not a rule at all, it's a myth.
The Best & Only When To Refinance Rule Of Thumb
DO THE MATH. DO THE MATH. DO THE MATH.
When it comes to home refinancing, you really need to see the process for what it is...possibly the LARGEST financial decision affecting your wealth that you will ever make. In one of the above examples the savings over 15 years exceeded $35,000. That's an EXTRA YEAR'S SALARY for many of us, 2080 hours of wages for which you didn't have to do any work. In another example, the losses were twice that over 30 years. Ouch! The only way you can be sure that you're saving and not losing is to DO THE MATH. You've seen me throwing out all of these trend figures for different points in time, without explanation for how I derived them. Now I'm going to show you how to calculate your refinance savings or losses for YOURSELF.
There are really only five factors involved in comparing the costs of a CURRENT loan to a REFINANCE loan for any point in time. They are:
1-Monthly Payments Difference Cost/Savings to date
2-Debt Consolidation Savings to date
3-Remaining Balances Difference
4-Cost of Refinance (Points & Fees)
5-Term Difference Savings to date
Our FIRST STEP is to subtract the CURRENT Monthly Payment from the NEW Monthly Payment.
Example: $1265.06 (CMP) - $1260.21 (NMP) = $4.85
The result is a gain of $4.85 per month. If ever this calculation results in a loss, be sure the number has a negative sign(-).
The NEXT STEP is to add any Debt Consolidation Savings to the result of the last calculation. (Remember, if the last calculation resulted in a loss you're essentially subtracting here, since you're adding a negative number.)
Example: $4.85 (MP Savings) + $250 (DC Savings) = $254.85
Now we need to know the point in time you wish to examine. Let's look at five years out. So that is a total of 60 months from now. Since in this example you're saving $254.85 every month that's a total savings of $15,291.00. Write this number down in a column.
The NEXT STEP is to determine the Remaining Balances for BOTH loans in five years. Using my Mortgage Payment Calculator will help make this easier. In this example, the beginning loan amount on the CURRENT mortgage was $208,000 at 6% for 30 years with zero points and $3000 in closing costs which were financed, and you've been in the mortgage for 15 years. If you input these figures you'll see that after 15 years in the mortgage, your CURRENT loan balance is $149,910.62. The amortization table shows that in five more years (20 years into the mortgage) your Remaining Balance will be $113,943.69. Now let's find out where the NEW loan will be in five years.
For this example, input a loan amount of $170,000 at 6% for 20 years. It also has 2 points and $2500 in closing costs, which are being input ONLY because they are being financed. (If you are paying points and fees out of pocket, DO NOT include them in this calculator input.) Hit the Calculate button and you'll see that after five years your Remaining Balance is $149,337.85. Subtract this NEW Remaining Balance from the CURRENT Remaining Balance.
Example: $113,943.69 (CRB) - $149,337.85 (NRB) = -$35,394.16* *Notice the result has a negative sign(-).
Add this negative number to the column with the $15,291.00. When you total these numbers it shows a TOTAL LOSS of -$20,103.16 after five years. In this example, this is the FINAL TOTAL after five years.
The last two of the five factors don't apply to this example. The Closing Costs don't need to be deducted here because they were financed, and their expense is accounted for in the Remaining Balance on the NEW loan. If we had not financed the points and fees, then you would determine their total cost and write it in the column as a negative number, totaling it with the other numbers in the column in order to account for the cost. And the last factor, Term Difference Savings, doesn't apply because we are only looking five years ahead. This factor has no effect until the term on the CURRENT mortgage has expired.
To show you how to account for this last factor, let's compare the same two loans but look 20 years ahead, five years after your CURRENT mortgage has expired. The monthly savings of $254.85 multiplied by 240 months, or 20 years, is $61,164.00. Write this in a new column, since it's a new point in time.
Now the Remaining Balances Difference after 20 years is actually $0.00. The CURRENT loan only had 15 years to go and the NEW loan was only for 20 years, so a zero balance minus a zero balance equals zero. Write a zero in the column.
The Closing Costs were financed and therefore accounted for, so the only remaining factor is the Term Differences Savings. Since your current mortgage expires in 15 years, but the new mortgage is for 20 years, this is the money you would NOT have to pay for the final five years if you STAY in your CURRENT mortgage. Your CURRENT monthly payment is $1265.06 and NOT paying that for 60 months would save you $75,903.60. This number is also written in the column, but as a negative since this is a loss you realize by taking this refinance. Total up the $61,164.00 and the $0.00 and the -$75,903.60 and you'll get a FINAL TOTAL LOSS of -$14,739.60 after 20 years or the life of the loan.
You can even double check this by using the TIL cost calculation as demonstrated at the beginning of this article.
Example: $227,702.38 (Remaining Cost) - $302,446.81 (New Cost) = -$74,744.43
This example's total loss is -$74,744.43 after 20 years. We already know the TIL can't account for Debt Consolidation Savings, so in order to make a true comparison we need to account for those savings. Now $250 a month over 240 months, or 20 years, is $60,000.00. When we add that $60,000.00 Debt Consolidation Savings to the TIL costs calculation result in the example above, the total result is a loss of -$14,744.43--nearly identical to the FINAL TOTAL LOSS of -$14,739.60 we were double checking. This is proof of the accuracy of this method and I hope you can see it's value.
I do admit, all this math can become a bit tedious, especially when looking at several different points in time for several different offers. If your interested in a great alternative to doing all of this math manually, you should check out the Trend Master Refinance Calculation Tool. It will do all of this math in a flash and show you in a user friendly way, exactly how your mortgage will affect you. It's really a fantastic tool. You can find out more by following the link provided below.
Advice From A Former Mortgage Professional
I STRONGLY ENCOURAGE you to create tables of each of your loan comparisons over several different points in time. Seeing the trends visually can be truly enlightening. Keep in mind the length of time you plan on staying in the home. I also highly, HIGHLY recommend you get multiple, read many, quotes from different lenders. A "Good Deal" means not only putting yourself in a better financial position, but also getting the best value in the current market.
THINK about that last sentence for a minute.
If a 2% interest decrease saves you $300 a month and $10,000 long term, is it a "Good Deal?" What if another lender was offering a 3% decrease at that time and it saved you $600 a month and $40,000 long term? Is the first offer still a "Good Deal" or a "Not So Good Deal?"
Look at it another way, if you bought a $60,000 car for $50,000, and then saw it somewhere else for $35,000, regardless of how much money you saved, you'd still probably feel cheated. That's because deep down you know you got a deal, but NOT a "Good Deal."
You should always explore the market. Multiple offers help give ALL of the offers a sense of scale and value. Utilize the methods I have given you here. Use my Mortgage Payment Calculator to assist you. Always DO THE MATH and look at the trends over time. Information is power.
Use the tools that work and throw out the tools that don't. Oversimplified when to refinance rules of thumb are tools that don't work. The Trend Master Refinance Calculation Tool is a tool that does work. Follow the link below to learn more about what it can do for you. You owe it to your pocketbook to at least check it out.
Another suggestion is to contact actual lenders. You're not obligated to anything until you sign at closing and it costs nothing to get a quote. Get the Good-Faith-Estimate and the Truth-in-Lending statements from each lender. They are REQUIRED BY LAW to provide them within 3 business days of application. Also ask for an amortization schedule as well, since it will show you the loan balances over time.
A final word. There are some fantastic online services that take most of the work out of mortgage shopping today. You can fill out just one online application and get back multiple offers very quickly. At that point you can apply my methods for each offer over several points in time and really see what action is best for you. And you should REPEAT this process until you are satisfied you have a "Good Deal."
Remember, it's not you against the banks, it's the banks against each other! That's your LEVERAGE! Use it!
Pass this information on to everyone you know. If we all know how to make informed decisions and spend money wisely, we add stability to our economy and to our future.
You can access the Mortgage Payment Calculator at http://www.enlightenedrefinance.com/Mortgage-Calculators.html
Get more information about the Trend Master Refinance Calculation Tool at http://www.enlightenedrefinance.com/Trend-Master-Details.html
______________________________________________________ "Take calculated risks. That is quite different from being rash." George S. Patton ______________________________________________________
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