Q: I’m retired, living in a condo. I have a first mortgage that is a 30-year at 5.875 percent. I pay $657 per month. My second mortgage is paid off.
I’ve been offered a refinance at 4.5 percent, which would cost me $572 per month. I’d save about $85 per month, but it will cost me $3,919 to close on the loan.
Should I do it?
A: Recently, I’ve been spending a lot of time talking about how you have to pay more attention to the total cash in the deal rather than the interest rate on the loan. You’ve been offered a deal that will cost about $4,000, and will save you $85 per month. At the end of year 1, you’ll have saved $1,020. At that rate, it will take you nearly 4 years to pay off the costs involved with the mortgage and to start saving real money.
But there are other important questions you’ll have to answer: Where will you be in 4 years? Is this the last mortgage you’re ever going to have? How far into your current mortgage are you? If you’re 15 years in and are resetting the bar to 30 years, you’re going to pay another 15 years’ worth of interest on top of $4,000 in closing costs. Then, you’re not saving money – you’re spending real money.
The only way to know for sure if the plan works is if you refinance your current loan balance, and you reduce the term of your loan to match the end date on your current loan, and you pay less money overall. And, you have to plan to be in the house for at least 5 to 7 years, to make the effort somewhat worthwhile.
You also need to make sure you understand the costs involved when you talk about the almost $4,000 you’re going to pay. If part of that amount is for real estate tax and insurance escrows that will go towards paying your expenses down the line, you should probably exclude those expenses from the calculation. And, if part of the $4,000 is prepaid interest on the loan – where the loan broker assumed you were closing on a day other than the first day of a month, you need to exclude that amount also.
If after you exclude prepaid interest and escrow charges, you’re left with closing costs closer to $2,000, it will still take you a little over 2 years to break even on the costs. You have to then decide how long you plan to stay in this house and keep the loan.
One last piece of advice: You should ask your loan broker to compute the amount you would pay per month if your new loan actually had to be paid off in full on the same date as your existing loan. When you refinance an existing loan that has only 25 years to go with a new loan that has 30 years to go, most of the initial monthly payments will go to paying the interest owed on the loan. But as you are further into the loan, even 5 years down the line, more of your monthly payment is a repayment of the principal rather than mortgage interest.
When you have both numbers computed to the same end date, you’ll be able to compare the actual amount you’ll pay monthly on an apples-to-apples basis. You may find that the expected $85 per month savings results from extending the term of your loan is actually less than that. If the savings is quite a bit less than $85 per month, the time it will take you to break even on the costs of refinancing is even longer, making a refinance even less worthwhile.
Please reassess your situation based on your answers to the above questions, and I’m sure you’ll figure out in which direction you need to go.
April 23, 2009