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REAL Home Economics from a frugal, practical, fiscally savvy working mom.

Wednesday, February 10, 2010

Don't rush to refinance - DO THE MATH

I've been writing cover letters lately and need to get in touch with my analytical side.  So, this is my chance to talk about mortgage rates and play with spreadsheets.  Yes, rates are low again and sooooo tempting.

Ever overhear people discussing how low their rate is?  (It's the grown-up version of competing over who has the car with the most horse power)!   As tempting as low rates are, refinancing can end up costing you more in the long run when you've had your current mortgage for a few years.  It's because most of your payment is interest at the beginning (paying the bank) and diminishes slowly until it flips about half way through (in 15 years) ...after that more of the payment is principle (paying yourself).  So, every time you refinance you go back to paying the bank more and yourself less!

Here is an example of the problem I'm trying to solve. 

What does the rate need to be for refinancing to be worth it - break-even point?
(Assuming I refinance my remaining principle balance 
since some of the original mortgage amount has been paid off). 
    So, I got out my trusty amortization spreadsheet to quantify the break even point so I can stop drooling over the bank ads and know when I should react.
    • Assumption
      My current $200,000 30-year mortgage is 5 years old at 5.375%

    • Results:  I was surprised!
      The interest rate needs to be less than 4.2% before I'd be ahead; assuming I'm holding the loan the full term.  Also, the analysis isn't taking into consideration all the bank fees and points.

      But, if I'm planning to sell my house before the loan ends then it changes everything... 
      my break-even refinance rate increases to 4.75% if it sell my house or payoff in 10 years.
    • Reason: The initial payments go almost entirely to interest so, when you refinance you get to pay more interest again & again.  That's the reason banks advertise rates and want you to refinance.  The good news is that the later years of your mortgage are mostly paying yourself equity. If you keep refinancing you never get to the golden years of your mortgage and you keep pushing out when you'll be debt free.   
    Pay yourself instead of the bank. You're better off making an extra payment annually (or rounding up your payment) and having a big party to celebrate being the first to pay off their mortgage!

    If I paid an extra $100 each month in the example above, the loan would be paid off 5 years earlier and save over $40,000 in interest.

    DO THE MATH (or ask someone to help you with it)!

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