When is it Smart to Refinance a Mortgage?

Ever since mortgage rates started falling I’ve been waiting for the best time to refinance our home mortgage.  A few months ago I received a promotional letter from the same mortgage broker I’ve used for our past two mortgage loan closings – one mortgage refinance and one original mortgage loan.  I’ve referred him to 8-10 friends and they’ve all used him so we have a good relationship now and always get good interest rates and low closing costs from him (He knows I still shop rates against him as a safeguard).  We started talking again and discussed when it would be smart to refinance our current mortgage and watched rates for a couple of weeks.

The main questions came down to how long we planned to stay in the house, if we wanted to take any equity out of our house and how much we wanted to come out of pocket in cash at the closing table. 

Our plan is for our current home to be our final home purchase so we have a long term horizon.  We bought it less than three and a half years ago and have more than 30% equity in it.  After we bought our starter house we began saving for our next/final house the next year and lucked out to have the starter house appreciate too.  Those two pieces together gave us a nice down payment for our new home.

We didn’t want to increase our principle balance and take money out of the deal.  Our goal is to pay the house off sooner so we have lower fixed expenses when we are ready to retire.  I’m not a big believer in the perceived benefit of writing off interest for tax purposes on a home loan versus not paying the interest in the first place (by paying off the house, not defaulting).  A home owner deducts interest from a home loan from income, not directly off of taxes owed.  That means that for every dollar spent on interest only 20-30 cents is saved on taxes.  That’s 70-80 cents wasted.  The counter argument is that with rates as low as they are today you can make more investing the money.  That can be valid I suppose, but as aggressive as I can be with my investments I like the diversification paying down my mortgage gives me.  The other option might be to keep our home loan principle balance higher thereby giving us more cash and then I could put part of my investments into safer bonds, but that would be at a lower return on investment and not guaranteed. 

We decided we didn’t want to pay more than $5,000 at closing and would roll the rest of the costs into the loan balance.  $5,000 was somewhat arbitrary, but was close to what I thought I had available in our account at the time I started talking with our mortgage broker. 

To decide when it was smartest time to refinance for us came down to how soon we’d see the benefit.  The best option for us was to pay no loan discount points (basically pre-paying interest) and low loan origination points (this is negotiable since it’s basically the commission the mortgage broker gets – We got it down to 0.375).  These two parts combined kept our closing costs lower.  We also dropped our home equity line of credit, aka HELOC, which was costing us $50/year to keep open and would only come into play after we spent our savings we keep in our CD ladder and our investments I blog about here all the time. 

I used the free mortgage calculator at bankrate.com to figure out the loan amortization schedule.  We reduced our payment by $233 per month.  Based on our 4.875% interest rate and approximately $6,250 in closing costs after our escrow refund it will take us 27 months to see a benefit from this refinance.  In other words, after 27 months we’ll owe less than we would have if we had not refinanced.  Every month after that puts us farther ahead.  Since we’re not short on cash flow right now, while we’re both still employed we plan to keep paying what we were used to paying before the refinance by adding $233 towards principle each month.  This will save seven years on our mortgage which means we’ll pay off our house around three and a half years sooner than if we had not refinanced.  If we don’t have to refinance again down the road we’ll have our house paid off in 23 years, soon after I turn 61.  We’d both like to retire before then.  Our son should graduate from college in about 17 years, not counting grad school if he decides to go that route.  Without a mortgage payment or child care costs our lowered fixed income will help us be able to retire with lower income restrictions.

By the time we closed this week a month and a half had passed since we planned our closing costs and how much we’d pay at the table.  We were off a good bit because we had made two payments since we first figured out our payoff cost and I didn’t expect to get as much of a refund from our escrow account as we did (escrow holds insurance and tax payments and pays on a quarterly or semi-annual basis in most cases).  We only paid $3,276 at closing and will get back more than $3,500 from our escrow.  That means I have an extra $5,000 to send in to our investing account today.  I thought about sending in an extra payment on our new mortgage, but decided to just stick to the original plan.  Once I get my investing account over $100k, I might consider sending more to pay the mortgage off sooner, but that’ll be a decision to make at the time.