A few weeks ago we closed on a refinance of our mortgage. We kicked off the process mid-February, before the COVID-19 storm really kicked in. We closed just shortly after the market did the dizzying drop mid-March.

Why refinance now? Rates had dipped in early February to the point where we could drop another .75% off our rate. Is that much of a drop worth it?

Let’s find out.

## Closing Costs

Banks don’t do refinances for free. Shocking, I know. Combine the loan origination fee, credit reports, appraisal fees, title insurance, and settlement/closing fees, and a refinance can start to get expensive.

In addition to the bank’s fees, local governments tack on recording fees and transfer taxes. Banks often don’t include this in their marketing because they depend on your locality which can be pretty variable. Not including them eases the sticker shock of a refinance. How convenient.

All total, we’re looking at just under $3k of fees.

## Less Interest?

The payment on the new loan is 62% of our original payment and the interest in the first payment on the new loan is almost $200 less than the old loan. Dividing our closing costs ($3k) by the monthly interest savings ($200) gives us a break-even point of 15 months.

So we’re winning, right?

Not so fast. The new loan resets the amortization. At our current rate, we had only 16 years left on our mortgage but the new loan stretches that back out to 30. We had $107k of interest left in the original loan. The new loan’s total interest is $174k, adding an additional $67k of interest if we make no effort to pay it down early.

Here’s a graph comparing our monthly interest payment for the original loan (blue), the monthly interest charge of the new loan (red) and the sum of the difference between them (yellow). The break-even point is where the yellow line crosses the $0 mark. Where the yellow line crosses the $0 mark a second time is the point when the refinance starts costing more than if we’d kept the original loan. The crossing of the blue and red lines is when the monthly interest for the refinanced loan exceeds the original loan’s monthly interest.

Looking at this chart, it’s clear that refinancing costs us more. However, the payment is smaller, giving us flexibility if our budget gets stressed. Is that worth $67k?

For us, refinancing to save .5% isn’t worth it. The yellow curve “kisses” the $0 line before plummeting down. However, refinancing to 2%–half of the original 4%–would break even on interest. Probably not a realistic rate, though.

## New Loan, Original Payment

What if we paid the new loan using the payment amount from our original loan? How would things look then?

We’d be including more principal with each payment and we’d pay less interest over the life of the loan. Instead of finishing our original loan in 16 years, we’d instead have the new loan paid off in 15. The new graph would look like this:

Instead of paying an additional $67k of interest over the life of the loan, we’d actually save $22k of interest.

## What About Paying Points?

Points are the process of paying interest up front in exchange for a lower interest rate. Using current rates, paying .827 points can reduce the rate an additional .25%.

Is it worth it?

Because we’re paying points, our closing costs are greater and our breakeven point gets pushed out to 24 months. The curve now goes above the $0 line for a longer period of time but still dips back below. We do save some interest on the loan, around $15k. But that’s only if we keep the loan for the full 30 years, which we probably won’t.

Paying points didn’t seem worth it.

Here’s the new curve:

## How About a 15-Year Mortgage?

While considering our refinance decisions, we looked at the idea of refinancing into a 15-year loan. Not surprisingly, 15-year mortgages come with a lower interest rate, but not as much as you’d hope for. At the time we refinanced we could have gotten a 15-year loan at 3% instead of 3.25%. The payment would have been almost equal to our current mortgage payment, which makes sense because the remaining time on our current mortgage is just 16 years.

So what would the interest deltas look like? Here’s a graph comparing our current mortgage interest to a 15-year at 3%:

That looks pretty similar to the scenario of a 30-year but paying the original payment. True, we’d save nearly $30k, an additional $10k of interest over the life of the loan, but we also would lose the option of paying a smaller amount should we ever need to temporarily scale back our monthly payments.

## Conclusion

Before refinancing, it makes sense to run the numbers. Each situation is different and the analysis above won’t line up with everyone’s reality. In our situation, it makes sense to refinance for a .75% drop, but then to continue paying it like it was the original loan. While a 15-year was tempting, I decided I didn’t want to sacrifice payment flexibility.

Here’s a final graph of our current mortgage balance trajectory, compared with the original loan and refinanced loan. We’ve a few additional principal payments over time and will probably continue to do so:

I’d love to hear about your refinancing thoughts.

Hasta luego!

Thanks for sharing the detailed analysis, David. I agree it always makes sense to run the numbers before you decide. I have heard that within the US that you can use the rule of thumb of it making sense to refinance if you can get a full 1% cheaper interest rate. What do you think of that rule of thumb?

1% is a good rule of thumb. There are always costs associated with refinances, and even if you can get the bank to pay many of them, there are usually still some left up to the home owner. It’s generally not worth the hassle for a .25% reduction.