With interest rates dropping to around four percent, I am getting a flurry of questions about refinancing. Interest rates are expected to stay low for more than a year. So, my general advice is to look before you leap.
Refinancing is not as good a deal as you may think. In January, 2009 at BREN, I outlined how refinancing can set back your long-term financial goals. If you refinance, but do not shorten your loan term (go from a 30-year to a 30-year), you are adding more payments to the end of your loan.
You borrowed $300,000 at five percent two years ago. Your monthly principal and interest is $1610 a month. You have paid $38,640 toward principal and interest over the past two years and $14,388 went toward principal, the other $24,252 went to interest.
The $285,612 you now owe would cost you $1533 a month without any change to your interest rate. You have added 24 more payments to the end of the loan. That’s $36,792 to save $77 a month. ($77 times 360 payments is $27,720.) That is obviously not worth it. You also have to add in closing costs, which can be thousands of dollars.
If you can get your rate down to four percent, the monthly payment goes down to $1364. You reduce your payments by $246 a month, and add $32,736 to your thirty-year payments. ($246 times 360 is $88,560.) That’s worth it.
There are more good reasons to refinance, even if you can’t afford to go to a shorter loan:
Cash flow: Paying less on mortgage every month gives you more money in your pocket for other spending. There is a value to money in your pocket. It may be needed for basic needs; it may be helpful in times of unemployment or underemployment. You can invest it. You can save it for a rainy day. Inflation will make your money worth less later.
You are likely to sell before you get to the end of the mortgage: For younger buyers who expect a trade-up or relocate in the future, this is especially true.
Most people do not stay in one home for 30 years. I generally advocate buying for the long term. I have a higher than typical number of clients who get to the end of their mortgage. Most of the people who have owned longer have enough equity to refinance now with little difficulty. They are also the ones that lose the most if they increase their loan term too much.
The other thing to be concerned about is your equity position. The reason: in order to refinance, they will have to buy PMI (mortgage insurance to cover loan), if they no longer have 20 percent equity. Owners who bought near peak or borrowed against equity along the road, may have dropped below that 20 percent mark.
Because of 80 percent loan limits to avoid PMI, a refinanced loan could cost more on a monthly basis. Owners don’t have to be under water to be too undercapitalized to refinance. They need to have a 20 percent equity share in the house to avoid PMI cost.
If you are thinking about refinancing, my advice is to get an idea of your equity. Call or write your agent. We will be able to give you a rough guess about what your house will appraise for.