Does it Pay to Refinance?

Often times, before writing a post on a general subject, I will scroll through the archives of the MortgageCalculator just to make sure that I haven’t already written an identical post. In this case, I was shocked to discover that I hadn’t ever written a post examining the process behind deciding whether to refinance one’s mortgage. While this subject is always relevant, it is especially so in this era of record low rates, and it’s about time that I devoted a post to it.

While this question would appear to be fairly straightforward, it is confused by the fact that every “expert” has a different standard that they use to answer it. Many advisers simply use the “1% rule” which states that it will be advantageous to refinance as long as rates have fallen by at least 1% compared to your existing mortgage. Others are even more aggressive, using .5%  as a basis for encouraging borrowers to refinance. Then there are those that insist that if you can save 0 per month, it’s probably worthwhile, and those that advise refinancing as long as you can recoup the costs of refinancing (in the form of lower payments) in 3-5 years. The vaguest simply urge you to refinance every year or so for as long as rates continue to fall. (They have fallen steadily since the early 1980s).

These kinds of back-of-the-envelope calculations however are far from scientific, and I don’t want to waste any more space talking about them. In fact, it’s relatively simple to determine whether its economical to refinance. Our Refinancing Calculator is probably the most complete one available on the web, taking into account a dozen factors. Most of the entry fields are self-explanatory, and you can start by plugging in the parameters that describe your current mortgage and your potential newly refinanced mortgage. Then, plug in the expected costs associated with the refinancing. Most calculators will actually stop at this point and simply compare your expected savings with the cost of refinancing.

The Mortgage Calculator Refinancing Calculator goes two steps further, by taking “Years Before Sell” and Tax Rates into account. As it turns out, these parameters are crucially important. For example, if you plan to sell your home within a few years, you may not have enough time to realize savings, and your refinancing will need to clear a higher hurdle. In addition, mortgage interest is tax-deductible, while (refinancing) closing costs and origination fees are not. Thus, any calculation that doesn’t take into account your marginal tax rates will overestimate your savings. After plugging in all of these parameters, simply click the Calculate button, and you will be told whether refinancing under these conditions will yield a gain/loss, as well as the potential size of these gains/losses.

For borrowers that are especially enterprising, the National Bureau of Economic Research has an Optimal Refinance Calculator that also includes inflation and a handful of other temporal factors, and computes the precise ‘break-even’ rate at which your refinancing will become economical. As implied by its name, the calculator aims to determine the best time to refinance: “The Optimal Refinance Calculator spits out tougher numbers than many other calculators in part because it factors in the benefit of waiting beyond the break-even for the chance that rates could fall further. Refinance now and you reduce your ability to refinance later.”

Lest I get ahead of myself, borrowers need to to ask themselves what home to gain from refinancing, in addition to achieving overall savings. Do you want to extend, shorten, or maintain the current duration of your mortgage? Do you want to put money in or take money out? If you previously had a 15-year mortgage, obtaining a new mortgage will automatically extend its duration. If you had a 30-year mortgage, you need to decide whether to shorten the duration or “start from scratch” with a fresh 30 years. Either way, you can choose to ignore the temptation of making drastically reduced payments, and choose to write a check for a higher amount every month. While this gives you flexibility in making payments, it also requires tremendous discipline.

As for the latter issue- that will probably be decided by the lender. While rates are currently very low, lending standards are very high, and you probably won’t be able to take cash-out. Currently, lenders require a Loan-to-Value ratio of at least 80%, 2 years of documented income history, high credit score, and maybe cash reserves. Any deviation from those lofty requirements will make it difficult for you to refinance and/or will necessitate a higher interest rate.

For more information and to determine if now is the time to refinance, you are advised to contact your lender.