True break-even point of a refinance

I mentioned in an earlier post that a decision to refinance often involves a calculation of the "break-even" point. A much-simplified version of this calculation is to take the cost of the loan and divide it by the amount each monthly payment is lowered. However, this fails to take into account the loan term: refinancing a 15-year loan into a 30-year one will drop your payments considerably, but at substantial cost in the long run. Even just refinancing from a partially-paid-off 30-year loan to a new full-term loan will drop the payment while extending the payoff.

A better indicator of true value here is the interest paid each month. This is entirely dependent on the interest rate and the outstanding balance on the loan.

Using this metric makes a 15-year loan look much better, which (let's face it) it is. The main draw is that the interest rates on 15-year loans are tons lower (over half a percentage point) than 30-year rates. On a large (200K) mortgage balance, this can mean a difference of eighty dollars or more in interest each month, no small change. The monthly payment is still higher (ours was 40% bigger when we switched), but it's because you're paying off your loan instead of paying basically only interest.

If you can afford a 15-year repayment schedule, it sure is worth a look in our current interest rate environment.

The thousand-dollar e-mail

We recently started the process of refinancing our house, due to the drop in interest rates since we took out our current loan. As part of that process, I obtained some quotes from different lenders. One lender came back offering a lot more in "lender credits" (money they'd pay toward the loan) than their nearest competitor. So we went with them.

Unfortunately, when they pulled our credit score, it came back a bit lower than anticipated. Nothing catastrophic, but it did make them drop the level of the lender credit by a thousand dollars. With this new knowledge (including my current credit score), I decided it would make sense to inquire at the other lender, too, and find out the lay of the land.

First, though, I decided to make lender #1 aware of this fact. I sent them a simple e-mail message saying that the more accurate quote was quite a bit lower, and I would therefore be asking for other quotes.

Within minutes, I had a phone call: it was my representative from lender #1, who informed me that he had spoken to his manager, and they would be willing to extend me the original quote (as if I'd had the higher credit score) if I stayed with them.

I accepted; it's not every day you can make a thousand dollars with an e-mail.

Stepping down the ladder

We're refinancing again. Even though it's only been a year since our last refinance. Why?

Mortgage rates are down. Even more than they were last time. And that spells opportunity.

Imagine a hypothetical couple, in a situation similar to ours was, but with arbitrary numbers:

$200,000 15-year mortgage at 3.25%
Credit score: 800

According to the lovely rate quote machine at mtgprofessor.com, such a couple could sign up for a 2.625% loan with zero lenders' points and fees. Of course, for that loan, they'd have to pay out of pocket for the miscellaneous costs involved in closing the loan. Thus, a refinance decision usually involves calculating a "break-even period", like this:

The closing costs for the loan will be four thousand dollars, but we're paying two hundred dollars less in each month's payment, so after 20 months (4000/200), we'll have paid less in monthly payments than we paid to refinance. As long as we keep the loan longer than that, it will be worth it.

The decision is essentially whether you'll have the loan longer than the break-even period.

However, just like you can pay "points" for a lower rate loan, the lender will pay you "negative points" to take a higher rate loan. As of a few days ago when I checked, a 2.875% loan will include almost four thousand dollars' worth of negative points. That is enough to cover all the costs of appraisal, closing, and lenders'  fees with room to spare. Any extra funds will be applied to the couple's escrow account, to pay for property taxes and insurance. Such a loan is called a "no-cost" loan---that is, even though there may be money required at closing, all the lender's fees and third-party fees are covered.

Even though 2.875% is higher than the "going rate", it's lower than the couple's current rate. Also, since the negative points pay for the loan and more, the typical "break-even" calculation isn't even applicable: our hypothetical couple is ahead of the game right from the start! If rates drop next month, and they want to refinance again, they can do it again, and again, without losing anything except possibly some credit score points after applying for all those loans.

This technique of serial, no-cost refinancing is sometimes referred to as "stepping down the ladder", and it has the benefit that you can refinance continually as long as it's advantageous. If rates go up, though, you just stick with the last loan you took: though it's not the lowest you could have got, it's pretty close, and you don't have to keep "bottom-calling" on the way. (I would have called the bottom on mortgage rates a couple years ago, but they still keep getting cheaper!)

"Stepping down the ladder" is a viable strategy for today's market of falling mortgage rates, and anyone can do it.

Further reference:

http://thefinancebuff.com/cost-mortgage-refinance-stepping-down.html

Helpful chart at http://thefinancebuff.com/mortage-refinance-fixed-rate-or-adjustable.html