Mortgage rates are back at historical lows with last week’s national average on a 30-year fixed rate loan (per Freddie Mac’s mortgage survey) at 3.53%.  Even if you just refinanced in the last year, it may be worth your while to explore re-financing again.  In very simplified terms, you can estimate whether refinancing makes sense for you by dividing the closing costs by the amount you’d save on your payment each month and comparing that number, which is frequently called the “payback”, with the amount of time you plan to stay in the home.  I like to call this “broker math” or “refi 101”.  The calculation is quick, easy, and gives a decent first indication of whether the refinance could be worthwhile.  In reality though, there are some additional considerations: 

1)     What are the real closing costs for the loan?  Some lenders quote their origination fee, but leave out third party fees in their initial estimates.  Others quote origination fee, third party fees, and “pre-paids”, which are partial month’s interest and/or an initial deposit to an escrow account of a few month’s property tax and hazard (homeowners) insurance.  Others still will quote “no out-of-pocket closing costs” because they will allow you finance the costs into the loan.  This doesn’t mean you’re not still paying them!  The true costs of the loan include the lender’s fees (origination, application, underwriting, and points) + all third party fees (appraisal, title insurance, taxes, recording, processing, legal, document).  Prepaid items (partial month’s mortgage interest and escrow) are not true costs and should not be factored into the analysis because they are not costs in connection with the loan.  The mortgage interest portion is the interest for the partial month if you close in the middle of the month, but you’ll get to skip one month’s mortgage payment so there’s an offset.  The escrow deposit isn’t a true cost because you’re just pre-paying something you’d have to pay at a later date anyway, and if you have an existing escrow account on your current loan, you’ll receive a refund from that shortly after closing.

2)     What is the real benefit of the lower monthly payment?  Simply looking at the lower payment as a complete benefit to you is not the correct way to view a refinance.  That’s because only a portion of the payment reduction is due to a reduction in interest.  In fact, there are four components to watch out for:

• (+)True interest reduction – this is your real benefit
• (-)Tax impact of the true interest reduction – if you itemize, a portion of the lower interest payment means that you’ll have a lower mortgage interest deduction which means you’ll pay higher tax.
• (-)Principal reduction from extending the term of your loan – not a real benefit because your mortgage is going to last for extra months on the end of the loan to account for this
• (-)Principal reduction from amortization schedule – not a real benefit because more of each payment will be going toward interest after the refinance, so if you sell the home a few years after the refinance, the principal balance will be higher than it would have been without the refinance.

Calculating all of these impacts is somewhat challenging.  We’ve developed excel models to do the calculations.  Contact your PWA financial advisor if you need help.

3)     Do you have enough equity in the home to avoid needing private mortgage insurance (“PMI”)?  To qualify for a traditional loan with no insurance (assuming good credit), you’ll need a loan-to-value (“LTV”) ratio of no more than 80%.  To calculate your LTV, simply divide your mortgage amount by your estimated home value.  If the result is < .8, you probably won’t need mortgage insurance.  If it’s > .8, you probably will and if you do, there could be other up-front costs in the loan or there will be an ongoing PMI payment which typically equates to an interest rate that’s about 1% higher than the one quoted on the loan.  Be careful.  You probably won’t want to refinance a loan that doesn’t have PMI to a loan that does have PMI unless your interest rate is falling by ~2% or more.

4)     Once you’ve compared the true up-front costs of the loan with the real monthly benefits of the lower payment, you can calculate your payback by dividing the benefits into the cost.  If you plan to remain not only in the home, but also in the loan, for longer than the payback, then the refinance makes sense.  But do you really know for certain that you’re going to be in the home AND in the loan at a certain point in time?  Probably not (especially if you might refinance again).  For this reason, I advise clients to double the payback period and if they’re still confident they’ll be in the home and the loan for that amount of time, then do the refinance.  If the confidence is not there, then refinancing could add cost without enough payback before you exit the loan through a sale or another refinance.

5)     Do you have enough equity to qualify for traditional financing?  There is a chance that you’ll go through the loan process, pay an appraisal and potentially an application fee, and find out that your home is worth less than you thought and your LTV is higher than 80%.  In that case, adding mortgage insurance may be the only way to continue with the refinance.  Doing so will add to the costs and likely will extend the payback period to the point where the loan no longer makes sense.  In this case, you won’t proceed with the refinance, but will still be out the appraisal and application fee.  So, you need to have a fairly good idea in the value of your home and that you’ll have enough equity before you refinance.

6)     Many lenders will quote a standard rate and closing cost combination when you ask for a quote.  But, there are other options in most cases.  For a refinance, especially in the case where you don’t know how long you’ll be in your home or whether rates will fall sharply and you’ll want to refinance again, the best option may be a slightly higher than market rate and a credit that offsets most or all of your closing costs.  In this case, you remove all of the cost by giving up a little of the benefit and make the payback zero (or close to zero) months.  Explore that with your broker/lender before making a decision based on an initial quote.

Determining whether or not to refinance is really an intricate cost / benefit analysis.  Many borrowers look only at the payment reduction and the amount of money they need out-of-pocket to close and may put themselves in a worse position by doing so.  Make sure you think through this decision and talk to your PWA advisor before and during the process.  Once you get this right, and you’re certain you’ll benefit, refinancing really can be a free lunch.  And, there’s no better tasting lunch than a free one.