Save Money Refinancing a Home Mortgage, Part I
As I write this, mortgage rates have come down significantly due to the actions of the Federal Reserve and the U.S. Treasury. They have come down very fast. This has created a frenzy in the market. Whenever dislocations in a market like this happen, watch out. There will be many more applicants than mortgage brokers to handle the volume which means that the brokers have incentive to hold out for the borrowers who will pay the most.
As Jack Guttentag writes, pricing is all over the board. Before you call the broker, you should have a good idea that a refinance will actually save you money. Mortgage brokers are salespeople and they are selling you a mortgage, they will often times try to convince you to buy even if it isn’t in your self interest.
In this post I will talk about some things you will want to consider. In a followup post I will go into detail using a sample mortgage and an online calculator.
First, What Your Broker Doesn’t Want You to Know
The mortgage broker doesn’t want to tell you that you should go back to your existing mortgage holder and ask for a mortgage modification. This is as close to a free lunch as you can get in the mortgage market because in addition to a rate reduction, they will keep the existing terms of your mortgage including the term. This means that all the equity you have been building in your payment (the percentage that goes to principal) will be maintained instead of starting over with a new mortgage.
The banks know this is a good deal, so you will likely get a new interest rate above fair market rates. This is OK, you will likely still be better off particularly if you have more years of your mortage paid off already.
Some years ago, I refinanced a mortgage this way. The only thing that changed was the rate (it went down 1%), there were no closing costs at all and the principal was the same (they didn’t roll closing costs into the mortgage). Due to the existing credit crisis, banks may not give these deals anymore so don’t be surprised if there are some closing costs.
Look at Total Cost, Not the Payment
I get annoyed at mortgage brokers who try lots of different schemes to get your mortgage payment down without considering if the mortgage will actually save you money over the entire term of the mortgage. There are a couple of ways they try to do this: offering a mortage at a longer term and rolling closing costs into the mortgage. If you have paid off 5 years of a 30 year mortgage, a refinance will restart your mortgage back to year 1. Even if your mortgage rate stays the same, the mortgage payment will go down because the term was increased. Closing costs added to the mortgage will not affect the payment significantly since it is amortized over the term, but it increases the total cost of the mortgage.
The broker will try to distract you by giving you an estimate of how long if will take to payoff the costs of the new loan using the ‘savings’ from the lower payment in the new loan. Don’t fall for it. Run the mortgage in a calculator to determine the savings.
Consider Interest Rate and Term
The goal of your refinance should be to reduce the total cost of the mortgage. A loan that costs less will let you keep more money in your pocket. Even if your interest rate drops 1%, you still may not get a new loan that will save you money, if you restart your term. If you are in this situation, consider dropping the term on the new loan. For example, if you are 7 years into a 30 year loan, consider refinancing down to a 20 or 15 year mortgage. This will let you keep all the ‘payment equity’ you have built in your existing 30 year loan. If your interest rate drops and you decrease the term on the new loan, it will be very hard not to save money.
Sorry to give you the bad news, but saving money on your mortgage will likely mean a larger monthly payment. This is easily seen when comparing a new 15 year loan versus a new 30 year loan. The monthly payment needs to be larger on the 15 year loan primarily because you are paying the principal down sooner. The quicker you pay off principal, the less interest that is charged.
In Part II, I demonstrate what was discussed here using online calculators.