Should I Refinance? Completing a Break-even Analysis

Last week, in my post Lessons Learned:  Financing My First Home, I wrote about buying my first home and the financing process behind obtaining it.  I mentioned briefly that you should do a break-even analysis anytime you are thinking of refinancing.  This could be a mortgage loan refinance, or something else like student loans or an auto loan.  What’s the best way to go about figuring out if the refinance is viable and the best choice?

As an accountant, I like to do this in a spreadsheet.  I have added the Excel file shown within this post to my new Templates page, where I intend to share my tools that you can use to become savvier. 

There are different scenarios to look at when doing a break-even analysis.  First, in a refinance, you shouldn’t consider “sunk costs” or money you have already spent on interest.  That’s because you have spent it and will not save anything in the future.  Let’s imagine you were thinking about refinancing from a 30 to a 15 year mortgage with the objective of paying less interest and owning your home free and clear, sooner.  Imagine the interest rate you have on your 30 year is 3.625% and the new rate would be 3.125% on a 15 year.  Also, let’s say you are three years (36 months) into paying your 30 year mortgage, so all the interest you have paid at the higher rate is a sunk cost.  According to my spreadsheet, you have paid interest of $27,804 (note: for this exercise, I am rounding to the nearest dollar).  This point is important because you will want to start at your current ending balance for the refinance, or $247,625.

Loan amortization schedule snapshots by W. Vance

Next, copy the tab and use your current ending balance for the refinance, or $247,625, as the loan amount.  If your loan officer tells you there is no “out-of-pocket” costs, you will need to add in the closing costs from your good faith estimate.  Let’s assume the costs to refinance come to $3,500.  This will need to be added in as your loan balance will increase, for a new loan balance of $251,125.  Change the interest rate to 3.125% and the term to 15 years.

Loan amortization schedule snapshots by W. Vance

You can already see you would save BIG by making this move if you take the total interest of the 30 year loan, less interest already paid, less interest that would be paid on the 15 year, less closing costs ($142,486-$27,804-$43,170-$3,500=$68,012).  This savings is if you assume you stay in the home for the next 15 years and would have paid the minimums on the 30 year mortgage. 

So, where is the break-even in all this? 

This part is where the Excel spreadsheet makes it easy to spot about when you will hit that magical point in time where you are profitable in your refinance.  To do this, I went back to the original, 30 year tab and added columns for the cumulative interest from the refi-point (December 01, 2017 in this case) and linked the cell for cumulative interest from the 15 year tab.  Then, I added in a difference tab (30 year cumulative interest, minus 15 year cumulative interest), and followed the total down until it was close to $3,500 in closing costs.  In this case, in month 31, or two years and seven months into the schedule, I would break-even on my refinance.

Loan amortization schedule snapshots by W. Vance

So, this seems like a lot of numbers and does it really matter?  I mean, a lower rate is always better, right? 

Not always!  Let’s say you started paying your 30 year like a 15 year.  Then your break-even would be much further down the road.  In this case, by not refinancing, you save the $3,500, but pay your old, slightly higher rate.  This means it takes even longer to break-even, which is at month 41, or about three and a half years.

Loan amortization schedule snapshots by W. Vance

Let’s imagine that I wanted to move to a new home and sell this one within the next three years.  Then it would be a bad move to refinance, because I wouldn’t recoup my closing costs with interest savings.  Doing nothing is better in this scenario.

Other Considerations besides savings and break-even points

Sometimes saving on interest looks good on paper, but may be more difficult to execute in real-life.  If you have seen a good increase in income since purchasing your home, and other goals are complete or well underway, then refinancing to save interest over the years may be a great move.  However, if you still need to build up emergency cash, kid’s college savings, or have consumer debt, you should hold steady and divert extra cash to those goals.  Also be careful that a higher mortgage payment doesn’t drive you into debt in other areas such as using credit cards to make up for the cash being spent on the house.  This defeats the whole purpose of a refinance and likely has you paying more interest because of the credit cards.  Only refinance if it saves you a considerable amount of interest and beware the temptation to fall for those ads to refinance and take cash out or lower your payment by resetting the amortization clock on your loan.  If you have 20 years left, and find rates have dropped, make sure you request a 20 year term and not a 30.  No one wants to be paying for their home long after their retirement, or worse yet, can’t retire because they took out a 30 year mortgage at age 55! 

Did I completely overwhelm you with all these calculations?  Don’t feel discouraged!  I’m an accountant and sometimes get carried away.  Send me a comment on your situation and I’m willing to help!

Lessons Learned: Financing My First Home

From Fortune.com via Getty Images

I can’t believe it has been 13 years since I started the process of buying my first, and current home.  I was intimidated.  I didn’t know a lot about the process and I was mostly scared of rejection.  For a long time, I didn’t think I would ever qualify.  My then significant other and I would drive around, looking at homes with for sale signs in the yard and talk about what we like or didn’t like, but we would always be taken back by the prices. 

Then, in April 2007, I found a new home development in the suburbs that seemed like it was in our price range.  We went and looked on a Saturday afternoon and liked what we saw.  The sales person happened to have attended high school with my significant other, which helped make us feel at ease.  In hindsight, we probably should have sought the help of a realtor, but we were naive and only in our mid-twenties. 

We went back the next day, Easter Sunday, and decided to take the big leap and go into contract.  I wanted to be a homeowner so bad.  I rationalized everything, and took the only lot available with the floorplan we could afford.  In hindsight, I wish we would have waited for a bigger lot.  The next week, we went to the affiliate mortgage company and applied for financing.  In order to keep the house under contract, it was required we get approved for financing.  An important part of getting a mortgage is to have a property picked out.  Without it, you can only get pre-approved, which is a good way to see how much home you qualify for, but is not that same thing.

We didn’t know much about the types of mortgages available, so we went with what the loan officer said was the best for us.  In hindsight, a 7/1 adjustable rate mortgage was not the best pick.  Payments were interest only for seven years, with an adjustable rate, then reset at regular payments for the remaining 23 years.  Five percent of the home price would be our down payment and 15% would be from a home equity line of credit (HELOC).  Prior to the 2008 financial meltdown, people could avoid private mortgage insurance (PMI) by financing this way, because the first mortgage was only 80% of the value. 

I believe these types of loan packages are a thing of the past (thankfully!).  I recommend a 15 or 30 year, fixed rate mortgage, with no points, unless someone else is paying those for you.  Points are prepaid interest that lets you buy down the rate so your payment is lower over the life of the loan.  Always do a break-even analysis with any type of refinance and see how long it will take to recoup the savings versus the higher rate.  If you are not planning on staying in your home longer than the breakeven point, then don’t spend the extra money and refinance or pay points.  To understand more about the different types of mortgage programs, visit this Bankrate page.

Once approved, we didn’t have a locked interest rate because our home was not slated to be completed for over four months.  Eventually, in June, we were able to lock our rate and know better what our monthly payment looked like.  At the same time, we were saving for our down payment, which back in 2007, was allowed to be stated, and not verified, as long as you had that amount by the time you closed.  Of course we made it and bought the house, rode the value down and in 2012 was able to refinance to a fixed-rate, 30 year loan, at 1/3 less interest.  This was made possible by the HARP program, which allowed people to refinance underwater mortgages that were at a higher rate or part of a sub-prime loan such as the one we were sold.

The lesson I learned is to always do your homework by understanding the different options available.  If you don’t qualify for a financing option you want, make sure you understand the reason.  If you feel uncomfortable with a mortgage officer, or company, then step away and call some other companies.  Also, remember that you are the customer and they want to sell you a loan because if not, they don’t get paid.  If you don’t qualify, or don’t feel good about the deal, chances are you will regret it.  Speak up and be your own advocate, and if you have an elder family member or friend who has been through the experience, don’t be afraid to ask them to sit with you, or at least look over the deal.  You can buy your first home, but make sure it is planned out well, or your home might own you and limit your life outside of making your monthly payment.

Do you have any home financing nightmares to share?  Leave a comment!