The Math On Refinancing

by FrugalBabe on August 9, 2010

Even though it’s only been a year since we bought our house, we had been hearing so much about how low interest rates are right now that we decided to look into the possibility of refinancing.  We spoke with a close family friend who works at a bank in the mortgage department.  Our current rate is 4.625, and she told us that she could get us down to 3.75%.  She said we could roll the closing costs into the loan and still end up with payments that would be about $200/month lower than what we pay now.  Sounds great, right?

We decided to sit down and crunch some numbers to see if this would really be a good idea.  We loved the thought of a 3.75% interest rate, but would refinancing really save us money in the long run?

You’ve probably seen personal finance websites that caution against looking just at the monthly payments when financing a car.  Instead, they advise that you look at the total purchase price plus total interest and consider the total cost of the vehicle rather than whether you can afford the monthly payments.  We do the same thing with our house.

The total cost of the house (principle amount plus total interest over the life of the loan) is more important to us than the monthly payment amount.  We plan to stay here forever (I know, we said that before… but this time we mean it!) or at least for a very long time, and paying off the loan is one of our top priorities.

We used a mortgage calculator from Bankrate, which I like because it allows you to enter odd numbers for the total length of the loan.  Here’s the nitty gritty:  We currently owe about $152,000 on our house.  Our interest rate is 4.625%, and we have about 12.5 years left on our 15 year loan (we’ve been in the house a year but we’ve been making extra payments ever since we moved in).

We can refinance at 3.75%, but it would start our loan over again at 15 years, and it would add about $4500 to the outstanding balance (refinancing would cost between 2 and 3 percent, and I’m going with the higher end to err on the conservative side).  So we would then owe about $156,500 on the new loan.

We pay extra on our loan every month, but there’s no way to be sure that we’ll always be able to do that.  So I wanted to look at both an early payoff scenario as well as the total interest we’d pay if we kept our mortgage for its full term.

In our current loan, if we stop paying extra and take the full 12.5 years to pay it off, we’ll pay about $48,400 in interest between now and the time we pay it off.  If we have the loan paid off five years from now (our goal), we’ll only pay $18,600 in interest between now and the time we pay off the house.

If we refinance and don’t make extra payments, we’ll have a payment about $200/month lower than what we have now, but it will be for 15 years rather than 12.5 years.  And over the course of that time, we’ll pay $48,400 in interest.  Yep – the same amount (I rounded my numbers, but the actual values were within $70 of each other).  If we refinance and then add the same amount of additional payment that would allow us to pay off our current loan in five years, it would take 5.5 years to pay off the new loan (because of the extra $4500 tacked on for closing costs).  And the total amount of interest paid would be about $16,900.  That is less than we’ll pay over the next five years with our current loan, but only by about $1700.  That is far less than the closing cost of the refinance, even if we were able to get a new loan with a 2% closing cost.

So basically, even though the monthly payment would be $200 lower, we’d still be paying the same amount of interest if we kept our loan for the full term, and we’d be paying for the closing costs of the loan too.  If we continue to pay extra each month in order to pay off the house quickly, we’d save about $1700 in interest with the new loan, but that doesn’t make up for the closing costs that would be tacked onto our loan in order to refinance.

So… we aren’t going to refinance.  Sure, it would give us a lower monthly payment, but that payment would be set for the next 15 years rather than the 12.5 years on our current loan.  And refinancing won’t really save us any money in the long run.

I know that it’s a great time to refinance if you’ve got a higher interest rate, but since our rate is already pretty low, the math just doesn’t work out.  Are any of you considering a refinance right now?  What’s more important to you – the monthly payment, or the total cost of the house?

Related posts:

  1. Real Estate Nitty Gritty
  2. Financing A Car
  3. How we used balance transfers (very carefully!)
  4. Our HELOC Repayment Plan
  5. What To Do With A Tax Refund?
  • http://thriftysassymama.blogspot.com Sassy

    Smart Move :) Glad to see you working out all the numbers instead of the most obvious one (like just the monthly payment). So many people nowdays don’t account all the numbers.

  • http://www.familybalancesheet.org Kristia@FamilyBalanceSheet

    We have refi’d several times since we bought our home in Sept 2001. We don’t do it for the lower payments, we do it to pay less for our home. We have always calculated the fees into the number to make sure it made sense. I switched our mortgage over to a home equity loan years ago which has made refinancing a lot easier and cheaper. We just refi’d to heloc that is currently at 2.74%. We were at 4.99%. We decided to be aggressive, because we want to pay the house off within the next 5 years. We’ll keep a close eye on the rates and if they creep up too much I’ll lock in. Our rate with the heloc will always be prime less .49%. Prime has been at 3.25% since dec 08, but I’m sure they’ll move up at some point, but it doesn’t usually jump dramatically. It will have to get to 5.49% before it will be worse than what I was at and I’m hoping by then it will be paid off. Low rates are a by-product of this unfortunate econcomy and I’m going to take advantage of them as much as possible.

  • http://la-stories.blogspot.com Don

    The question is whether it would save money if you kept your current repayment schedule. It seems that prepayment is an obvious question to settle before agreeing to any refinancing (also at that rate, it seems like it might be a variable rate loan which seems a questionable thing to jump into with rates where they are at the moment). But IF it is fixed rate and it allows prepayment and the lifetime savings on interest offset the closing costs with the accelerated payment schedule (and it sounds like it might not), then yes, it’s a bad idea to refi.

    On the flipside, there’s also the time value of money to take into consideration: The idea that a dollar next year is worth less right now than a dollar this year. Of course this assumes that we are in an economic situation in which there is some level of inflation. If we enter into a deflationary spiral, then all debt is bad.

  • http://pennilessparenting.com Penniless Parenting

    Nice new blog layout! What’s the occasion?

  • FrugalBabe

    Penny – no occasion, just a glitch with my old theme! It was giving trouble, and I’d had it for quite a while, so it was time for a new look :)

    Don – There are definitely lots of scenarios to consider. We would never take out a variable loan on our house. We had a HELOC for 15% of the value of our old house, and I hated the way the rate would fluctuate – can’t imagine that I’d get any sleep at all if our whole loan was like that! Our current loan is fixed, and the 3.75 loan would have also been fixed. We ran both scenarios (paying the loan off as scheduled, and also making additional payments) and in neither scenario would we recoup the closing costs. There’s just no way that I could see refinancing as a good option for us.

  • Mary

    Did you look in to a 10 year mortgage? The bank should be able to tell you if that is an option for you, but it would save you money in the long run.

  • FrugalBabe

    Mary,
    Yes, we looked at a ten year loan too. The interest rate was just about the same as the rate on a 15 year loan, and we still would have had to pay the same closing costs. We’re planning to have our loan paid off in about five years, so we can save the money ourselves without having to add $3000 – $4500 to the principle of our loan in the form of closing costs.

  • http://dianescholten.wordpress.com Diane

    You & I think alike! This IS a math problem, nothing fancier than that – the numbers work or they don’t. I came to the same conclusion on my 4.625% 20 year fixed – I’m better served by paying down the principle as much as I can, as fast as I can. Thanks for a great blog – I appreciate you!

  • bogart

    Great post. We did refi from a 15- to a 30-year fixed, reducing our monthly payment (and interest by around 0.75%), but costing us money (probably) in the long term. However, we felt that the wiggle room this inserted in our budget at a point right before my DH was retiring and moving to a pension much more modest than his salary would be valuable — and of course that it might well be hard to refi once he was a pensioner (um, for the record, he retired early and I’m a good bit younger than him. So while we do have mortgage debt in his retirement, it’s not quite as crazy as it sounds …).

    Overall we are happy with this decision, even understanding the costs it entails. Once we’ve achieved some other goals (including some travel before our youngest starts kindergarten), we do plan to start paying the mortgage down well ahead of schedule. Meanwhile at around 4.25 pre-tax, it’s very, very cheap debt …

  • Kaytee

    I like the new color scheme and revised layout.

  • http://www.experienceaurie.com Aurie

    As a person whose professional experience is in banking as well: This is exactly what most people don’t do when they look into doing a refinance. I’m glad that you showed this. If your net savings on a mortgage isn’t more than 1%, it is rarely a profitable endeavor because of all the fees. My recommendation is always to hunker down with a comfortable fixed rate loan (since the taxes will always be the variable portion of your monthly payment if you escrow). The way to save money on large balances is by reducing the time value instead of the monthly payment if you can afford to do so. Instead of lowering the monthly payment, reduce the time left to pay so that you can forego some of that interest that you would have to pay if you paid exactly the way the amortization/payment schedule stipulated. If you can’t afford to over pay every month, then create a plain vanilla savings fund specifically for payment down the principal on the mortgage on a quarterly basis – you get the idea.

    This was an excellent post and I really hope people are listening to you. You’re going about this the best way as an informed consumer.

  • Tiffany

    We just bought our first house, and monthly payment was the most important thing for us. We are just starting out, juggling school loans and car loans. That being said, we looked at the total cost and freaked! Right now, we signed up for the bi-weekly payment plan so we end up paying extra on the mortgage each year. We’re aggressively paying our school loans and car loans, and plan to be out of that debt in 1.5 years. At that point, we’re going to start throwing the extra money towards the mortgage!

  • Sandra

    Great post .. and I’m jealous of your current rate! Ours is at 6.25% and I’d LOVE to refi ..but hubs quit his job this past March to do his own business … so the banks said it’s not possible until he’s been in business for 2 years-booo!

    So wished we would have refi’d sooner .. but we didn’t .. so guess we’ll have to wait it out. :-/

  • Amber

    Purchased our house in 2006 — rate is just below 7% — we took our a HELOAN (fixed rate /lump sum) to fix up the house after closing. We are finishing some projects this summer and plan to refinance and hopefully roll the HELOAN into one 15 year fixed mortgage. Right now we’re at 10 years on the HELOAN and 30 on the mortgage. With the lower rates, we were looking at the same payment monthly, but much less in interest. Since the rates have continued to fall, I think it will be even more of a savings now as I crunched the numbers a few months ago.

  • http://mybasementgym.com/ Sara

    I agree with the others – great post on a matter where many don’t do all the math to figure out what’s best in the long run. :) I just wanted to add that many credit unions now offer flat rate closing fees. We recently did a re-fi from a 30 yr fixed to a 15 yr fixed, and when I was gathering the numbers, found out that the credit union we had our mortgage at offered a flat rate for closing costs and application fee that was under $1200 – no matter the size of the loan. When I purchased the house, the fees had been waived altogether for their first time buyers program – an offer still available several years later. Some web searches showed other credit unions with similar fixed rates for mortgages. :D

  • http://radioventriloquist.blogspot.com GC

    Great decision. I’m glad you spelled it out in words, not just numbers. I get why you’re not refinancing. I’m inclined to think it’s always a bad decision but the way you explained it, I understand how it can be a good choice for some people.

  • Gin

    Great post. It drives me wild to hear people I know talking about refinancing–they got “such a good deal” lowering their interest rate slightly, or rolling their new car purchase into it (!!!), but they didn’t really do the math beyond what their payment will be every month. (Granted, I know the monthly payments can sometimes make or break the deal, but this is not the case with these particular people.)

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