Should I Refinance? How Much Lower Should Your Rate be to Make Sense?

Should I Refinance? That’s a common question that is often answered a little too brazenly by rules of thumb that don’t necessarily make a lot of sense.  It’s kind of like saying “You should buy and house and not rent” or “you should own stocks and not bonds”.  It kind of depends on your personal situation, in this case, primarily time horizon.  I see over and over the “1% difference in rates” mantra spoken like gospel.  Article after article says if you can’t get a rate at least 1% lower than your current rate, it’s not worth it to refinance.  The thinking is that given the costs involved in a refinance, in order to offset those costs, there obviously has to be some threshold for a refinance to make sense.  In theory though, over a long enough period of time, ANY improvement in your rate should be a prudent move.  However, there’s always that present value of money issue and closing costs which might make say, a .125% improvement ineffective.  However, rather than going with a blanket 1% spread in order to make your decision, let’s delve into some assumptions and calculations that can help you make a more informed decision.  As you’ll see, even if you have a seemingly low rate of 5.25% today, you may still save money in the long-run by refinancing with just a 0.5% spread down to today’s average of around 4.75%.

Refinance Questions to Ask Yourself

• Term – Make a best estimate as to how long you’re going to be in that new mortgage.  If you’re likely to move in the next year or two, it may not make sense to refinance (but let’s check later).  If you’re certain this is your dream home and you’ll be there for 20 years or more, it will be a no-brainer and perhaps you should refi at even a smaller spread like 0.375% (again, let’s check that).

• Closing Costs (Everything Including the Kitchen Sink) – Closing (again on your own home ironically) carries with it a surprisingly high number of costs and fees.  Make sure to get a Good Faith Estimate from your lender and ensure that AT closing, there are no additional fees that didn’t appear on the GFE.  If there are, you can walk, right?  It’s not like you don’t still own your house.  But in comparing options and pricing, typical fees will include Title insurance, processing fees, mail fees, appraisal, etc.  Don’t be fooled by the “no fee” closing because closing costs are simply rolled into a higher rate, thus boosting your outlays over time.

• Discount Rate – What else could you be earning with that money?  For instance, if you have access to some exotic investment class like real estate, venture capital, peer lending or some other means are consistently earn say, 10% per year with minimal volatility, then you have a great opportunity to perhaps earn more elsewhere.  However, if you’re a mere mortal like the rest of us and you’re seeing 2-3% in CDs and lower in savings, perhaps you consider your “opportunity cost” something in the 4-5% range assuming you typically invest in a mix of risk-free assets and stocks which could reasonably earn high single digits annually, but with significant volatility in any given year.  I’ll assume a 4.5% discount rate for myself since I feel I can reasonably earn that much over time given my asset mix.

With these questions answered, you can simply construct a Net Present Value model in Excel (“=NPV” function) to see if your costs justify a refinance.  There are numerous ways to approach the situation, but what I’ve constructed is a model to simply look at your upfront cost (refi closing costs), your annual savings (due to the spread in the old and new interest rates) and your discount rate (could your money be better invested elsewhere?) to deliver an NPV.

I’ve included the formulas for your viewing pleasure so you can see how to set this up yourself (click image to enlarge).  You can get the monthly payments (to come up with annual savings) from any mortgage calculator.  In this hypothetical example, even with a spread of just 0.625%, over a 10 year period, there is a favorable result in TODAY’S DOLLARS of $6,898.  That’s what NPV is all about – it accounts for the future value of money by converting it to today’s dollars.  For the nitpickers out there, yes, by refinancing, you do alter the amortization of your old loan by starting over and this is offset by the renewed tax benefit for mortgage interest that’s higher at the beginning of a loan.  It won’t be a perfect wash of course, but without splitting hairs, I’ll assume it’s a wash and exclude both factors and focus on straight dollars excluding taxes.  For more expert money saving tips, check out other great personal finance blogs I follow or stop back in!

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