2. I hear this a good bit and it’s like nails on a chalk board to me. The term of the loan is just one piece of
the equation. The term tells us the maximum time until it has to be paid off and sets monthly payments
accordingly. Unless you have a pre‐payment penalty, something I never write, there is no rule against
paying any of or the entire loan off at any point so you are in total control of the loan, the amortization
or term simply gives us a deadline and a means to determine minimum monthly payment. So really,
does the term matter at all provided you have an actual game plan in place?
Example:
Objection: Well your proposal is going to cost me $1,000 in closing costs and it’s going to put my
loan back out to 30 years, in order prevent out of pocket cash for the costs and setting
up the new escrow account your loan amount is higher than my payoff, and the monthly
savings just isn’t enough. I just don’t think it makes sense…..
In the words of Lee Corso, not so fast my friend…….
Existing loan: $255,000 at 4.875% with 28 years remaining on the term. (336 months)
$1349.48/mo P&I payment
$248,787 remaining balance
$453,425.28 total of remaining payments
New loan: $250,000 at 4.25%, 30 year fixed rate mortgage. (360 months)
$1,229.85/mo P&I payment, savings of $119.63/mo
$442,745.91 total of all 360 payments
Comparing the two takes looking at several strategies, below are different ways to handle the savings.
You have to plug it in “somehow or someway” to get a feel for how the reduction in rate impacts your
overall financial agenda.
Option 1‐ Do nothing and just let monthly difference fall into your day to day budget/spending.
This to me is the least attractive but it must be considered. To compare it under the “do nothing
agenda” you have to look at the sum of payments remaining vs. sum of all new payments. You would
save $10,679.09 and from that you’d have to subtract your cost of $1,000 giving you a “net benefit” of
$9,679.09. so that does make sense but I would never advise this be the path because that’s a lot of
money at once but over 30 years you wouldn’t really and truly know the difference.
Option 2‐ You’ve budgeted for the existing payment so why not just keep making it? Making the
same payment but on the new mortgage at the lower rate we begin to see the separation. Under that
scenario a couple of things happen.
The total dollar amount paid falls off a cliff…. It’s now $407,451.44 which is lower than paying the same
amount for the next 28 years. How does that happen? Because you’ve now paid the loan off in 302
months which means you have effectively cut 5 years off the term of the new loan and cut 3 years off
the term compared to the existing loan.
4. Conclusion to this rebuttal is simple…..4.875% is a low interest rate, but 4.25% is a lot lower. If your cost
to achieve that rate is held low AND a plan is put in place for how to handle the realized monthly
savings, who cares whether or not the maximum term of the loan is extended back to 30 years. Can you
imagine how these numbers would look if your current mortgage was at 5.25% or 5.5% or 6%? It
exponentially increases the urgency to visit your situation.
3) “You say the cost is $1,000 but there is another $2500 in “prepaids”….that’s money I have to
spend so it’s a cost and should be factored into my cost/benefit analysis right?”
Not really….here’s why.
If you escrow your current mortgage, which most people do. Every month your payment includes 1/12th
of your total homeowners insurance premium and 1/12th of your yearly tax bill. The servicer to whom
you make your payments then takes that portion of the monthly payment and puts it into a savings
account. (To simplify it we’ll call it a savings account.) Then every year when your insurance and taxes
are due, they cut a check to the agent or the county/city to make sure that both items are paid on time.
That said, if you refinance and close today, your first payment will be due on November 1st of this year. If
your insurance premium is due in November, you’ll be about 12 months short right? you never made a
payment, it came due, and the escrow account balance would otherwise be $0. Same thing with taxes,
however many months you would pay between now and when the tax bill is due will be less than what
needs to be there. But you have been making those payments to the other mortgage right? Well that
savings account is still there and you still have money in it and it’s still YOUR money. In other words
when the refinance closes and the old mortgage is paid off, they have to send you back that money
because you paid it but they never had the chance to pay the premium or the tax bill and you get it
back.
So if you have a refinance with that $2500 in prepaids, roughly $2000 (estimating only based on a lot of
experience) would be in the existing escrow account and therefore would be coming back to you. that’s
still $500 short though…..
The rest will be interest. When you make your payment on September 1, you actually paid for the
interest accrued over the month of August. You’ve paid in arrears, this is the way all mortgage loans
work and is the opposite of rent. When I pay rent on 9/1, I actually pay for the right to live there over
the month to come, the mortgage pays for the month that was. So using our closing of today from the
escrow example, your first new payment would be due on 11/1 right? which would pay for Octobers
interest right? Well if you never make an October payment then how are the remaining days of
September paid for? Bingo….prepaid interest at the closing. So the difference between the escrow
refunds and the prepaids on the new loan, 99% of the time, is going to be negated by the fact you miss a
payment. This is VERY important and is not to be neglected in your calculations on cost/benefit.
In short, the prepaid line item on your good faith is not part of the equation on the cost/benefit but will
factor into your best execution structure of the loan. (Do I get a new loan for the exact pay off and bring
$2500 to the table or do I write the $2500 into the loan and negate my out of pocket? Things like that
5. should be addressed with your mortgage professional based on current position financially,
needs/wants, convenience, upcoming expenses, etc.)
As we just worked through these examples, hopefully you noticed the following:
‐ The amount the interest rate is reduced and the benefit in that reduction isn’t the same thing.
I’m not saying “rate isn’t important” but it’s not important as the raw number itself as much as
it’s only important in how effects your plan.
‐ Term is only part the equation and not the single piece to make your decision on. The term of
the loan is relevant only in how it effects the minimum monthly payment.
‐ Cost isn’t a cut and dry number and money has to be accounted for in areas that aren’t truly
costs.
Any mortgage, large or small, needs to be approached from a big picture planning position and not from
any rule of thumb. By using any of these objections/assumptions to the refinancing process you are
severely increasing the chance that you will let today’s fantastic opportunity slip by. How much benefit
would you get from seeing the additional $50k+ added to your net worth over the next 23 years?
Retirement planning or retiring early, paying college tuition, eliminating other consumer debt, caring
for your parents as they age, having your first child (or 2nd, 3rd, etc…..) and the list goes on. These are
topics that are of concern and should be discussed with your mortgage professional on how best to
achieve these goals. Discussing how much the rate is dropping is getting off the real topic if you think
about it in those terms.