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Choose Wisely: Deciding if Refinancing is Worth it

If you bought a house in the last few years, now might be a great time to refinance to lower your monthly payment or shorten the term of the loan.

Rates have dropped as central banks cut short term lending rates and foreign investors continue to flock to the relative value of long term US debt. How do you know if the appraisal fees, closing costs, and hassle are worth it?

An old rule of thumb from mortgage companies says if the monthly savings of your new mortgage recoup the cost of the refinancing within two years, go for it. This assumes you’ll own the property the whole time. No sense in refinancing just to turn around and sell it right away.

However, this heuristic is overly simplistic. Mortgage lenders make money through origination fees and from bundling your new loan with hundreds of others and selling them to large “servicing” banks. You have probably seen this a few months after closing via a form letter directing you to send future payments to a new bank.

The more loans they refinance, the more money they make. This volume incentive leads to constant pressure on homeowners to refinance and produce more origination fees. Junk mail and radio ads telling you to use equity from your home, lower your payment, pay off other debt, yada yada yada.

What mortgage companies don’t go out of their way to tell you is your new loan is reamortized and extended when you refinance. As a refresher, amortization keeps your payments static over the course of the loan by front loading the interest and gradually increasing the amount that goes to principal.

Say you bought a home three years ago with a 30 year fixed mortgage at 4.5%. In the first year, 26.5% of your payments have gone to principal and 73.5% has gone to interest. After year 2, 27.1% has gone principal. By year 3, 27.8% of your payments have gone to principal. Run your own mortgage numbers at Credit Karma’s mortgage calculator.

If you refinance, you reset the clock. Yes, your payment is lower, but now you have a new loan for 30 years, not 27.  You’re back to square one on the amortization schedule. That means paying more interest then you might have expected.

The eventual cumulative interest savings are also misleading. They are spread over 30 years while the costs of the refinance are payable out of your pocket up-front. Savings tomorrow versus costs today. Is your financial spider sense tingling?

It’s a future value versus present value problem!

Restating things a bit, a refinance is worth it if the present value of the future interest savings are greater than the out of pocket costs of the refinance today, plus an adjustment in case rates fall even further (i.e. your opportunity cost for refinancing today).

So how do we make this an apples to apples comparison?

After wading through NBER and Google Scholar for examples of papers looking at this problem, I finally found the Holy Grail I was looking for.

Buried in the text of Optimal Mortgage Refinancing: A Closed Form Solution is a reference to a financial calculator from Kalotay and Associates, itself based on a paper by Kalotay, Yang and Fabozzi. Brief tangent: Fabozzi is a member of the Fixed Income Analysts Society’s Hall of Fame and is one of the key contributors to the CFA Program’s fixed income curriculum, which I found one of the most enjoyable sections during my studies. #legendstatus

This simple calculator allows you to input your current mortgage information and the potential refinance information, including any points and closing costs.

The output is the present value of the interest savings over the course of the new loan and a simple yes/no/maybe answer to if you have a deal on your hands given the refinance costs and current rate environment.

If you’d like to turbocharge your interest savings, consider paying a little extra to principal on the new loan to keep the term the same as your original loan. You’ll still pay less each month than before!

After finding this Holy Grail of a calculator, I was curious how widely publicized it was.

Out of all the financial bloggers and websites out there, only one has mentioned it: the esteemed Harry Sit over at The Finance Buff almost ten years ago. I’m glad I’m to be in such good company, but it needs even wider coverage.

So don’t just take my word for it. Choose wisely and refinance the right way.

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