Friday, September 24, 2010

The Hidden Cost of Refinancing - Part Two

In a previous article, I talked about how refinancing can end up being a bad deal because you are extending the life of your mortgage and, as a consequence, adding to the amount of interest you are paying on your loan.  However, one assumption that I made was that the borrower was going to not sell his or her house for the duration of the mortgage.  As we know, that assumption doesn't always hold.  A large number of homeowners end up selling before their mortgages are paid off.  People trade up for a bigger home when they have kids, trade down for a smaller home when the kids leave home, relocate for a new job, or experience some other life event which forces them to sell.  How does this affect the decision to refinance?

Let's assume, as we did in my previous analysis, that you are looking to refinance an existing 30 year mortgage with another 30 year mortgage, and you are not going to take out any cash at closing.  In this situation, the main benefit of refinancing is that you are going to lower your monthly payments.  However, there are two costs that offset this benefit:
  1. The closing cost associated with refinancing.  This is usually paid up front when refinancing.
  2. The fact that equity is going to build up more slowly than it would have under the original mortgage.
Most online mortgage refinance calculators base their recommendations on whether or not to refinance solely on comparing the drop in monthly payments versus the closing costs.  They don't take into account the fact that you will be building up less equity in your house by refinancing.  The more equity you build up in your house, the more money you get the keep when you sell it.  Therefore, this becomes very important should you decide to sell your house before your mortgage has expired.

The question is how much of effect does this have?

To examine this, let's assume again that your original mortgage is a 30 year loan for $300,000 at 6%.  Now let's assume that you can refinance it with another 30 year loan at 4.5%.  Finally, we will assume that the closing costs to refinance are $5000.  Will we come out ahead by refinancing?

I ran the numbers two ways.  First, I looked at the scenario where you are refinancing your original mortgage after making payments on it for 5 years.  Then, I looked at the scenario where you are refinancing after 10 years.  If you remember from the previous article.  If you refinanced after 5 years and held onto your house for the life of the mortgage, you would come out ahead by refinancing.  However, if you refinanced after 10 years and held onto your house, you would come out way behind.  The question becomes how far ahead or behind would you be if you sold your house before the mortgage was paid off.

The graph below shows how far ahead/behind you would be under both scenarios if you sold after N years:

Refinance Analysis.  Source:

The blue line shows your profit if you refinance your original mortgage after 5 years.  As you can see, if you sold your house within 2 years of refinancing, you'd end up behind.  This is because the decrease in monthly payments doesn't make up for the fact that you paid $5000 in closing costs to refinance.  However, after year 3, you would end up ahead no matter when you sold.

The interesting thing, though, is that the benefit from refinancing actually peaks at around year 19.  If you sold 19 years after you refinanced, you would be over $44,000 ahead than if you held your original mortgage.  However, your profit starts to drop if you sell after that.  Why is that?
The way a mortgage works is that in the early years of your mortgage, the amount of principal that you pay is quite small.  If you look at your mortgage statement in the first year, you will see that most of your money goes towards paying interest.  However, the situation reverses itself in the later years of your mortgages.  In these years, most of your payment goes towards paying down principal.  If in the case of refinancing after 5 years, you had stayed in your original mortgage you would be in year 25.  At this point, you would be paying a significant portion of your monthly payment to towards principal.  However, with the refinanced mortgage, you are only in year 19.  Therefore you are paying less towards principal.  It turns out that the additional principal that you would have paid under your original mortgage is enough to offset the fact that your payments are less under the refinanced mortgage.  This starts to eat away at your profits.  Fortunately, it is not enough to drop your profits below zero at any point.

The red line shows your profit if you refinance your original mortgage after 10 years.  Again, you are in the red if you sell your house within 2 years of refinancing.  However, you start coming out ahead if you sell after year 3.  In this scenario, your profit peaks in year 12, and then it starts to drop.  Eventually, after 20 years, you are again in the red.  As with the first scenario, the lower payments on the refinanced mortgage are offset by the slower accumulation of principal.  However, there comes a time when you end up behind.  If you plan to stay in your house at least another 20 years, you are better off keeping your current mortgage.

The bottom line is that if you are planning to sell your house before your mortgage is paid off, you need to consider two things when you are deciding to refinance:
  1. You need to plan on staying in your home long enough to recoup your closing costs.
  2. You need to plan on selling before the slower accumulation of principal offsets the savings in lower payments.
The problem, of course, is figuring out if you are always going to come out ahead, like in the first scenario, or if there is a point when you will come out behind, like in the second scenario.  Unfortunately, most online refinancing calculators do not help in this regard.  Many are hosted by mortgage lenders and brokers.  Obviously, they have a vested interest in convincing homeowners to refinance, so they won't show you anything that might dissuade you from refinancing. 

Maybe a "smarter" refinance calculator should be my next project.  Hmmmm...

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