The following guest post is by Greg McFarlane of Control Your Cash.
When you write a book about personal finance, as rudimentary as it might be, friends ask your opinions on matters fiscal. A few days ago, I received this pithy email from one of the most financially conservative people I know:
When does it make sense to re-fi a house? We have 108k left at 6¼% fixed.
You need a little background (or his detailed history.) He bought the house in question in January 2003, for $185,000, and put 34% of the purchase price down (told you he was conservative.)
So…that means he’s 92 months into a 360-month mortgage, with credit that’s close to perfect.
His email didn’t say much, but it’s reasonable to assume that he’s talking about 30-year mortgages, similar to the one he already has. It goes without saying that he’ll be going from one fixed-rate into another. Adjustable-rate mortgages are essentially roulette wheels with fewer colors. There’s some other things we assume, such as:
- This is his only mortgage
- His credit is excellent
- He’s not doing this so he can get a home equity loan, which is really nothing more than a cash advance attached to a big piece of collateral made out of bricks and mortar.
The reason Bob wants to refi is clear – 30-year rates now average 4.34%, or 191 basis points less than what he’s been paying all these years. Bob figures that his already small monthly payment of $749 might go down a few more bucks if he refinances.
The good news is that given these parameters ($108,000 loan, 4.34%, 30 years), Bob’s new payment will be $537.
To save $212 a month, Bob’s going to have to pay around $2500 up front in closing costs. These fees vary profoundly throughout North America – they could be $1000 in some places, $5000 in others. Closing costs could include document prep, title insurance, recording fees, courier fees, surveying, attorneys and settlement fees, flood certification (even though Bob lives 2000’ above sea level in the middle of the desert), a credit report, pest inspection, processing, brokers’ fees, funding fees…you get the idea.
The closing costs mean Bob won’t truly be ahead for another year. And at that point, he’s got 29 years of payments to look forward to. Oh, you didn’t know that? Yeah, when you refinance you’re really buying the house all over again. When the time comes to write the final mortgage check, Bob will be as old as John McCain is now. John McCain will be as old as Jamie Moyer is now.
There’s an alternative. 15-year rates are now 3.82% (5 years from now, we’re going to look back at this time and wonder why people weren’t stealing silver to buy houses with.) If the math works out, Bob could save money and pay off his mortgage faster than he ever intended.
How much to borrow $108,000 at that rate for that long a period?
One more time, The Most Important Formula In Personal Finance. (Boldface mine. Formula courtesy of God, the same Divine Being who brought you the quadratic equation and π.) Monthly payments are:
x is the amount borrowed, y the interest rate, z the length of the term in months: that’s 108,000, .0382 and 180 respectively.
You can plug in the numbers yourself. You’ll find that monthly payments will be about $40 more than Bob’s paying right now.
But, he’ll pay the mortgage off 8 years faster.
Is Bob going anywhere, geographically speaking? No. He’s got one wife, one dog, zero kids and zero plans to add any. The neighborhood isn’t Beverly Hills, but it’s a lot closer to that than it is to East St. Louis. (That’s Rosedale and Vancouver’s Downtown Eastside, respectively, for Canadian readers.) If Bob were to move out before 2016, it’d make sense for him to reduce his obligation by doing nothing more than making one extra mortgage payment annually, and sending the lender a registered letter explaining that the payment is to entirely to the principal.
If there’s anyone who should refinance, it’s people in Bob’s situation – those who put a ton of money down at a time when the cheapest available interest rate was 44% more expensive than it is now. If you bought in the early noughts, as Bob did, then regardless of how good a deal you got on the house, you probably (think) you got burned on the mortgage. 6¼% sounds like usury today, but it was fair and equitable then.
What about people paying rates even higher than Bob’s? Homeowners holding mortgages from the ‘80s paid far more in interest than Bob is paying, considering that rates maxed out at around 18% back then. So shouldn’t people holding 18% mortgages refinance?
Hell and no. a) They probably refinanced already, and b) look at the dates. Paying 18% is miserable, but if you bought your house back when rates were that high, your sentence is almost over. The house will be yours freely and clearly soon enough.
Zillow tells us that Bob’s house has depreciated to about $150,000, which is an important criterion for starting the process of Bob “buying the house again” with a new 15-year mortgage. Assuming Zillow’s estimate is accurate, it represents a 13% decline from 10 months ago. But even if Zillow’s number is a little low, it just means that Bob has an even greater equity position in the house.
In short, he should refinance. And if you can knock 243 basis points off your mortgage, shorten your obligation by 8 years, and still be in the house by the time you’ve amortized any new closing costs, so should you.
Greg McFarlane is an advertising copywriter who lives in Las Vegas and Lahaina. He recently wrote Control Your Cash: Making Money Make Sense, a financial primer for people in their 20s and 30s who know nothing about money. Buy the book here (physical) or here (Kindle) and reach Greg at greg@ControlYourCash.com.