Rates have dropped! I mean really dropped. As I write this 30 year mortgages are less than 3%. That is really a staggering number. Keep in mind the the Federal Reserve target for an inflation rate is 2%. So banks, and their investors are basically telling you they are willing to lend you money, for 30 years, at a rate that just barely beats inflation. We all probably don’t fully grasp what an opportunity it is to be a borrower (and, how terrible it is to be a saver) in our time. If you have a mortgage, it really means you should take a look at a brand spankin’ new mortgage (Refinance!) but it doesn’t necessarily mean you should pull the trigger and if you do, what flavor of loan should you get? Like many other aspects of the financial world, this can be (intentionally) confusing. (People make a lot of money on the general public confusion over some rather simple math, and try to keep the confusion as high as possible to maintain their utility).
To add to the confusion, there are experts simultaneously advocating completely opposite points of view when it comes to mortgages. Some will argue paying as many points as you can, some paying none. Some argue paying off the loan as early as possible with the shortest possible terms, some say stretch it out as long as you can. There isn’t a uniform rule on when to refinance. How can all of these points of view be right? Well sometimes it really is because one opinion really isn’t very informed, but usually the answer is that there isn’t a one-size fits all approach and what is right for one person is not right for another. It depends on many personal factors, which means what’s really important is for you to understand the process so you can judge for yourself.
Let’s start with the mortgage itself, which is simply a loan secured with your home (actually, if you are getting a mortgage, it’s probably more accurate to say its more the bank’s home than yours…but it sounds really awkward to say you’re heading over to your mom’s bank’s house). There are really three (good) reasons to take out a loan for something you can’t buy with cash. One, because you believe you can make a higher return with the money than the rate at which you are borrowing (this is the essential business of banks). Two, because buying something you can’t currently afford is necessary for life (meaning, a car required to get you to work, not a car that enhances your perceived awesomeness). Or three, if there is a once in a lifetime opportunity, and the benefit is worth the interest payments (careful with this one, I’m thinking more like seeing one of the 7 wonders of the world, not Justin Bieber, but hey, to each their own) . A home generally appreciates in value and allows you to live a lifestyle much greater than you could if you had to pay for your living arrangements with cash, and you need a place to live, so homes generally meet the loan criteria. But important to remember, any time you are taking on loan of any type you are agreeing to pay extra money for essentially nothing. You get no product or service for the interest you are paying. Therefore it’s important that you are very sure about the investment opportunity if it’s reason number one, or the lifestyle improvement justifies the interest payment if it’s reason number two or three.
Once you decide that living in a home is worthy of a loan, and generally it is, then you have some decisions to make on the length of the loan, comparing fees, or paying points up front. Down the road if rates drop,you may also be faced with the decision of whether or not to refinance again, which is simply getting a new loan to replace the old loan.
When to refinance can be a tricky question, but doesn’t have to be. Note, the reason to refinance should be that rates have dropped sufficiently to allow you to have the exact same thing (live in your home) for less money. It is not because it’s a great opportunity to borrow even more money to buy more stuff. The real estate collapse of 2006-2007 really should have only impacted people who were unlucky enough to buy homes in the few years just prior to that who bought a home at the market peak. Instead it swept up many, many more people because as the housing market exploded in price in the early 2000’s, people refinanced with the purpose of “pulling money out of their home” or put another way “took on much more debt for no real reason other than their home price was artificially inflated”.
The easiest way to compare your current mortgage to refinance offers of all different types and all different durations is to assume all of the expenses associated with getting a new loan are going to be rolled into the new mortgage. In other words, the starting point of your current mortgage is your current balance and the starting point of any refinance mortgage is your current mortgage balance plus fees associated with the refinance (everything except the “escrow pre-paids” which usually includes local property taxes and insurance. These are included in the fees, and you have to pay them, but you’d have to pay these anyway eventually, even without refinancing).
Aside on fees. One expensive one is title insurance. This is insurance you pay in case a prior owner that sold you the house doesn’t have a “clean” title–like maybe someone did work for the person who built the house and never gets paid, they come after the homeowner, which is now you. The bank forces you to buy this insurance for them, but your policy is optional, and the closing companies aren’t always very clear that this is insurance you don’t have to buy for yourself. I personally have never seen a good investigation of the risk of these claims and average liability, so don’t have a good way to judge if this premium is reasonable or not…but my sense is that the risk is low and the premium is very high. I always opt out of this coverage.
Back to my refinance calculation. For each year going forward, calculate the total payments made for the year (the PMT function in excel is best for this) and the mortgage balance at the end of the year (the starting mortgage balance minus all the principal payments for the year, which you can get using the PPMT function in excel). Add these two numbers, total payments for the year + mortgage balance at the end of the year. Do this for any competing refinance offer also, including all variants of points you can pay, which as stated above, we’d be rolling into the starting mortgage balance. Repeat this for year 2, 3, 4 out to as long as you’ll be in the home.
Now look across each column each year. The lowest number is the best deal for that year. What you’ll probably see is that your current mortgage might still be the winner after year one or two, but if the competing refinance rate is at least a percentage point lower, you should start to see some of the refinance offers be a better deal. Also, you should see that paying fewer points are a better deal for those early years, but eventually the loans with more points become the better deal. This is done by design.
Mortgage points simply represent interest that you pay up front. Any time you pay for anything up front vs over time you should always be getting a discount. So if you are comparing mortgages for the total interest paid over the typical 30 years of the loan, the ones with the most points should absolutely be the best deal at 30 years. Aha! Easy answer! Why do they even offer those other loans with less points?
There’s one key variable the above calculation forgets. How many people get a 30 year loan and actually pay it off over the 30 years? Almost none. The average time in a home is 9 years. And note, that is the average time in a home, what you really need to know is how long you’re going to be in the loan. Even if you’re sure you are going to live in the home forever, are you sure interest rates won’t drop so much that you’ll be able to refinance again? If you look at the same mortgage comparisons over 2-3 years instead of 30 years, those with less points start looking a lot better.
So now that you have your table, what you need to decide is the length of time you’ll be in the loan. When deciding if to refinance, and after, what offer to use, it is mostly a personal decision on where you think you’ll be living in the near future and where you think interest rates will go in the future. This is why for some people paying nearly no points is smart and for some people paying maximum points is smart. If you feel like you’re going to be in the home for at least 5 years, and all the refinance offers are a better deal at 2 years…it seems like you should probably pull the trigger, but if you think rates will continue to drop, you might want to wait. In any case, look at all types of loans (10, 15, 30 year) and all types of offers (multiple banks with multiple points and fees) using the approach above to determine the best deal.
Refinancing can be a pain, so it has to be worth your time and trouble, but you should absolutely keep an eye on mortgage rates all the time, and be able to understand how to act as they drop.