With mortgage interest rates recently touching their lowest in more than 50 years, many homeowners are asking themselves if now is the time to refinance.
After all, it’s hard not to swoon at the thought of a 30-year fixed mortgage at 4.15 percent (the average rate for the week ending August 18, with 0.7 points, according to Freddie Mac), or 3.36 percent with an average 0.6 point for a 5/1 ARM.
With a $200,000 balance, a homeowner refinancing at those rates would get a $972 monthly payment at 4.15 percent, or $883 if they went with the 5/1 ARM. Assuming they currently have a 6 percent mortgage loan, a refinance would save them $227 or $316 a month, respectively. Heck, even if the original mortgage rate was 4.5%, they would save $41 or $130 a month.
But whether a mortgage refinance makes financial sense isn’t solely determined by interest rates and monthly payments.
For years, homeowners have been conditioned into thinking that low interest rates are the main reason to consider a new mortgage – but all those radio and TV commercials don’t tell the whole story.
One way to understand whether you are truly better off refinancing – or if you should spare yourself the trouble and stick with your existing mortgage – is by calculating the so-called net benefit.
What is “net benefit”? It’s a way of forecasting your actual costs, payments and balances for years ahead, to see which loan leaves you with more money in the bank.
Don’t worry: it sounds more complicated than it really is. Here’s how your can determine the net benefit of a mortgage refinance.
Can You Be Worse Off with a Lower Rate?
Most people don’t think that’s possible, but the reality is that a lower rate does not necessarily mean an overall benefit to you. Here’s an example.
Let’s say your current mortgage rate is 4.5 percent. That’s a pretty good rate, but the current rates are even better. Your loan officer tells you that he could get you a refinance that would reduce your rate and lower your payment. You tell him that you’re planning on selling your house in 13 years, so it may not make sense with all of the costs involved. Your loan officer says not to worry: he can get you a 30-year fixed at 4.25 percent–and he will take care of all of the costs. It’s a no brainer: you get a lower rate at no cost.
Sounds like a good deal, right? Not necessarily.
Let’s make a few more assumptions. For example, say your original loan amount was $200,000 and you’ve had that loan for 10 years. (Yes, we realize that mortgage rates were higher than 4.5% a decade ago, but remember that we’re using those numbers to help illustrate how net benefit works.)
So your current loan has a payment of $1,013 per month. Over the past 10 years, you’ve paid the balance down to $160,179. If you refinanced today to a 30-year fixed $160,179 loan at 4.25%, you will have a lower payment, $788 per month. (There are plenty of online tools to calculate a mortgage payment based on loan balance and interest rate, you can use this one at SmartMoney.com.)
So over the next 13 years, you will save $225 per month. Lowering your mortgage payment is no doubt a good thing, because you can invest that money and make it grow. Let’s assume that you put that money you save every month into a savings account earning 2% interest, and in 13 years it will grow to $40,047. (Use this calculator if you’d like to change any of those assumptions and figure out how much your monthly contributions will grow.)
So you will definitely have more money in your savings account that will come in handy when you retire, but that is only half of the story. The other half is what happens to your remaining principal balance. Thirteen years from now, your original loan would have a remaining balance of $72,904. The refinance loan would have a remaining balance of $114,324. In short: your balance would be higher by $41,420.
The reason for this is the amortization schedule. On you original loan, you had already gotten past the years of relatively little principal reduction and your loan was really starting to pay down. On your new loan, the clock starts over and you revert back to a minimal principal pay down that occurs at the beginning of a 30-year loan. So while you were reducing your payment with the rate, you were also reducing the amount of that payment that was going to principal.
Long story short: if you refinanced, you would have $40,047 more in a savings account, but $41,420 less in equity. Assuming you sell the property in 13 years as planned, you would be $1,373 worse off with a refinance than if you did nothing at all. It seems counter intuitive to most homeowners, but it’s true.
The Point of Calculating Net Benefit
If lowering your rate or payment could theoretically make you worse off, how would you design a system that could account for this? That is one of the main purposes of calculating net benefit: using the actual costs and benefits of each loan, adjusted for your time horizon.
With mortgage refinance (or any refinance loan for that matter), it ultimately comes down to the difference between payments and closing costs, adjusted for time and the net effect on principal balance in the end.
So the next time a loan officer calls you to see if you are interested in refinancing to today’s low interest rates, ask him to calculate the net benefit for you. He’ll probably tell you that he’ll need to get back to you. If he does ever get back to you, ask him to run net benefit numbers with every other loan product that is on the market today so you can compare.