Should I refinance my current mortgage? Banks/mortgage companies want you to refinance your loans because they will make more money from you. Sure, they may advertise lower rates, lower payments and show pictures of smiling people having fun. Make no mistake: unless you do the math, odds are they will take more of your money.
With interest rates still low by historic standards, lots of folks have been refinancing to lock in lower payments. Add a booming housing market to the mix, and people are refinancing and withdrawing additional equity from their homes in droves. It seems like we get solicitations weekly from our own lender.
By the way, we’ve made this mistake too. Twice! Please learn from our missteps so you don’t have to make the same mistake.
Buying a House Is Like Buying a Car
Let’s start with an analogy. You are at the car dealership shopping for a different, used Camry. You have $2,000 in cash and want to stick to a 20% down payment. Therefore, your budget is $10,000. If you put down 20%, you need to borrow $8,000 to complete the purchase. For a 3 year auto loan at 3.69%, your monthly payment is $235.09.
Then the sales person says, “you know, I can get you into a new Camry for the same monthly payment.” Your ears perk up. New car smell for the same monthly payment? Maintenance free miles at the same price? Tell me more about how I could get more swagger for the same dollars.
You can’t, of course. Let’s see how this trick works.
For starters, take the first scenario and multiply the monthly payment of $235.09 times 12 for an annual total of $2821.08. Then multiply that times the 3 years you will have the loan. Your $10,000 car actually costs $10,463.25. The 463.25 is the interest you will pay over the life of the loan. That’s what financing will cost you. What could you do with that extra money if you just bought with cash?
Now let’s look at how our crafty dealer can get you more car for the same monthly payment. We’ll keep the interest rate the same, but we’ll push out the loan duration to 7 years. Let’s see how much we can borrow while keeping the payment no higher than $235.09. Looks like $17,375! Woo hoo! With your $2,000 in cash, you have a total of $19,375 to throw around. New car smell, here we come. The real costs of this upgrade are your indebtedness for an extra 4 years and a total of $2,367.03 in interest. Your $19,735 Camry actually costs you $21,742.03 over the life of the loan.
If you spend any time on “how much house can I afford?” websites, you’ll usually see that they focus on what your monthly payment will be. And, it works! According to an expert at Fannie Mae, 90+% of US home mortgages are 30 year loans.
Buying a House With a Loan Spends Your Future Earnings Today
Now, let’s scale it up. Houses usually cost more than cars. And, at least in the US, we accept 30 years as the typical amortization period. Once you sign on the lines, you have effectively pre-spent 30 years worth of income. (There’s a reason mortgage contains “mort” the french root word for death)
Why Banks Love New Mortgages (and especially mortgage refinancing)
I remember when we signed our first mortgage. We were pretty young. We knew this was not going to be our dream house, but it was our first house. Despite doing lots of homework, we never really had any one challenge our approach or suggest there might be another way (like house hacking). So, we went for a 30 year note to keep the payments low. The total interest we would pay over the life of the loan was almost double the principal. Let’s dig into how a mortgage is structured to better understand things from the bank’s view.
Let’s start with the concept of amortization. When you take out a loan, a lender gives you a sum of money. You agree to pay that sum back over time. The lender charges you interest as their price for the service of loaning you money. An amortization schedule is the sequence of payments over time where how you agree to repay the lender. By the way, amortization comes from old French/Latin. It means to “kill it off”. As in to destroy an asset that generates revenue. When you pay off your loan, you have killed one of the lender’s assets. Do you think they really want their assets killed off? (Hint: no!)
So you have a new letter in the main offering a mortgage refinance. Sounds interesting, right? Lenders love new mortgages because so much of a borrower’s payment goes towards interest. You need to look at an amortization schedule so you can see why. The amortization table shows the monthly payments for the life of the loan. It is your repayment plan. It also shows how much of each payment goes towards paying down principal and how much goes to interest. You can also see how much total principal and interest a borrower has paid.
Here’s a simple example. Let’s say a borrower took out a $200,000 mortgage. The duration is 30 years and the interest rate is fixed for the life of the loan at 4% per year. With these terms, each month, the borrower commits to pay $954.83. Because this is a 30 year loan, the full amortization table is 360 rows long. So, here’s a condensed summary showing every 36 months instead (with a couple extra highlight rows added).
It Can Take Years Before You Pay More Principal Than Interest
A few observations from the table above:
- Initially, almost 70% of the monthly payments are used to pay interest. Yes, you might be writing $1000 checks every month, but when you start, only $300 of that pays off the balance. $700 goes to your lender’s pocket.
- It takes until the 154th payment (almost 13 years in) before 50% of the payment is applied to principal.
- You have to wait until the 283rd payment (23 years!) before your cumulative principal payments outpace your cumulative interest payments.
Wait…what!?
No wonder bankers wear fancy suits! A new loan generates significantly more interest (potential profit) than an old loan. And, the longer the term (e.g., 30 years vs. 15 years), the more favorable the loan is for the lender.
Most People Do Not Pay Down The Full Balance Their Mortgages
Now that we understand why lenders have such a strong incentive to get you into a new loan, we can add another wrinkle. Mortgage companies/banks know you are unlikely to keep the loan to the end. According to the National Association of Realtors, the overall US “median duration of home ownership is 13 years.” And lots of folks complete a mortgage refinance even without moving. With rapid turnover on a 30 year mortgage, it can be difficult to build equity because so much of one’s payments go towards interest for so long.
That’s right. The 30 year fixed note that 96% of us sign up for is closed after 13 years. In our example above, that’s right about when each payment finally has 50% going towards principal. And a substantial number of folks close their mortgages before 13 years, meaning they accumulate even less cumulative principal payments than interest.
In addition, the lender gets the closing fees associated with originating the new loan (that’s the mortgage refinance). They get the most profitable period of time for the loan (where you gain the least equity and they gain the most interest). And then, as borrowers, we start their most profitable revenue stream all over again when we refinance or move. Who is winning here?
Now we know why banks sends so many refinance offers. It’s not really because they want to see us lower our monthly payments. What are the top selling points of these marketing campaigns? We can lower your rate. We can lower your monthly payments.
Now you understand why looking at just rate or monthly payments is a red herring. Unless your name is Jeff, Oprah, or Bill, you probably aren’t paying cash for your house. Or, maybe you want to take advantage of historically low mortgage rates. What are mere mortals to do?
Look at Your Potential Mortgage Refinance Like an Accountant
- Run the numbers like an accountant.
- Calculate time to be free of the debt.
- Figure out how much less (or more) interest you will pay.
- Bonus/Caveat: think about opportunity cost
First, run the numbers like an accountant: yes, you should consider your monthly payments. If you’re in a cash flow crunch (there is a pandemic on after all), freeing up several hundred dollars each month may be a huge relief. But understand that the short term relief comes with a long term cost. That’s why you need to look at more than just a lower rate/monthly payment.
Consider how much faster you can pay off the note. If you move from a 30 year to a 15 year note, depending on your original terms, you may get similar or smaller monthly payments and a shorter time horizon. For most people, eliminating the house payment eliminates the second biggest single line item in a family’s budget (hint: taxes are usually #1). And, anything that puts time back in your pocket aligns with our main life goal. “Time is the ultimate non-renewable resource”, after all.
Finally, look at how much less (or more) interest you will pay over the life of the new loan vs. your current note. If the change in interest rates is big enough, maybe you can justify refinancing into a new 30 year note. For us, we’re 10 years in, so it becomes really hard to make this criteria work because we’re mostly past the most expensive part of the mortgage now (smacks forehead).
Caveat/Bonus – Don’t Forget About Opportunity Cost
Don’t forget about opportunity cost. This is the counter example that could toss out all of the math and analysis we’ve talked about above — which is why it’s so important to mention.
The counter-example goes like this, “if you can do something else with the money that earns a higher rate of return for your risk tolerance, you could consider that instead.” This means, you might be able to refinance your mortgage into a 30 year loan at 3%, saving a few hundred dollars each month. If you can re-invest those dollars into something that returns more (e.g., a rental property earning 8%), you will have become the bank. You are now borrowing money at a low rate to invest it at a higher rate. And, that’s not a bad place to be.
Of course, there be dragons here too. The higher rate may come with more risk. And, this is why personal finance is … well… personal.
A Better Mortgage Refinance Calculator
One of the nice things about not trying to sell you mortgage products means we can tell it like it is. So we built a refinance calculator so you can compare two different mortgages to see if you can win on all 3 dimensions: monthly payments, time to freedom, and total interest paid to your lender.
Let’s walk through an example and then make the tool available. Consider our example from above: a $200,000 30 year mortgage at 4%. Let’s say the note started 1/1/2018. The borrower considers a couple refinancing scenarios.
- Mortgage refinance to a new 30 year note at 3.25%
- Mortgage refinance to a new 20 year note at 3.00%
In both cases, we’re holding the cost of refinancing fixed at 1.5% of the value of the new loan (although that is adjustable too). In the first scenario, the borrower has a lower monthly payment by about $228/mo. Because of the lower rate, they also save on interest over the life of the loan…not too bad. However, they’re pushing out the payoff date by almost 4 years. For some this is a great trade-off: more money in their pockets every month but slightly more time carrying debt.
On to scenario 2. What if the borrower chooses to go with a 20 year note at a slightly lower interest rate? They don’t get the same monthly savings…the new monthly payment is only $30/month less. However, they save over $60,000 over the life of the new loan. And, they are debt free 6 years earlier. That’s what I would look for in a refinance: accelerating my Speed to Freedom!
Coming soon! A mortgage refinance calculator upgrade that lets you have a shorter time horizon.