Mortgage Refinancing Decision – How to

Saving money drove our mortgage refinancing decision, which is, but one from a myriad of reasons for refinancing. Some common causes are:

• Save Money.
• Reduce Interest Rate.
• Reduce monthly payment – sometimes even with a higher interest rate, refinancing could reduce the monthly payment, if the loan is spread over a longer term as compared to the old one.
• Reduce or Increase Risk – Refinancing from a 30-year fixed to an ARM mortgage increases risk while the other way around reduces risk.
• Changing the type of mortgage – Refinancing from a 30-year fixed to a 15-year fixed or vice-versa.
• Cash Withdrawal – This increases the outstanding loan balance and could increase the monthly payment as well. They are a good option if there is equity tied up in the house and cash is required at a comparatively low interest rate. The glaring fact is that a part of the house is essentially given away as collateral for the amount taken out.
• Consolidating other debt – again, the downside is that the collateral is your house.

The benefit reaped from refinancing is directly dependent on the motive and for most of the causes cited above it is an easy decision. For instance, if the objective is to reduce monthly payments, the primary parameter is whether the interest rates are lower than the current amount – the affordability of the closing costs, the time to recoup the closing costs, and the effect of any difference in terms between the two mortgages are secondary factors. It is refinancing to save money that is not a straightforward decision.

Mortgage refinancing for saving money is hard to quantify given the number of variables involved. The mortgage industry has a Rolodex of guidelines to help arrive at the mortgage refinancing decision, which is counterproductive for the most part:

• A popular ploy among lenders is to float a figure in the range of 1-2% as a threshold – largely flawed for such a simple formula is accurate only for a small minority.
• Another familiar industry tactic is the calculation that focuses solely on the time required to recoup closing costs and endorse refinancing if ownership of the house is expected to surpass the duration required to recoup the closing costs. The obvious, but overlooked faux pas with this approach is that it down plays to insignificant the effect of extending the mortgage era – refinancing a 30-year mortgage for a lower interest rate after 5 years results in a new 30 year mortgage essentially adding five more years of mortgage.

Although the calculations can be complex, there are ways to make an informed mortgage refinancing decision. One way is to add closing costs back into the loan amount and determine the point at which the loan balances overlap for the old mortgage compared to the new one. Please see below for a sample spreadsheet showing this calculation:

The spreadsheet indicates that it makes sense to refinance if you plan to stay in the house for six years or more. Another way involves determining the present value of the costs involved in a refinancing decision:

1. Closing costs
2. The net present value (NPV) of future cash flows for the difference in the remaining mortgage period. The NPV formula needs a discount rate which makes this value variable depending on your assumptions.

Once the present values of the costs are determined, in the amortization table for the new mortgage, determine the point at which the savings from each monthly payment add up to the present value. The sample spreadsheet below shows this calculation:

The spreadsheet indicates that it makes sense to refinance if you plan to stay in the house for six years or more. The former method is more intuitive and gives you an exact time period. The latter method allows for a little bit more flexibility (discount rate adjustments).

Be extremely wary of these two potentially huge pitfalls when making the mortgage refinancing decision:

1. Recourse vs non-Recourse Debt: Some states have a non-recourse provision whereby the bank cannot come after one’s other assets, should one decide to walk away from the home. In such states, most first mortgages are classified as non-recourse while refinanced mortgages are recourse. Should there be a chance that walking away is a possibility, then it might makes sense to not refinance at all, even at the cost of higher monthly payments. 
2. Prepayment Penalty: Many loans come with the dreaded prepayment penalty whereby the bank can collect a huge fee, if the loan is prepaid. This can be a huge deterrent when it comes time to refinance. The only way to avoid this situation is to ask and ensure that the loans do not have this penalty clause.

Related Posts:

• Home Owner Loans - Playing the Mortgage Game 
• Home Improvement Loans - A Primer
• Good Faith Estimates and Settlement Charges - An Introduction for Home Buyers
• HOA Management - A double-edged sword for homeowners
• Taxes, Laws, and Regulations - A Primer for New Homeowners
• Home Ownership - A Peek at Periodic Costs
• Mortgage Refinancing Decision - How To

Last Updated: 03/2012.