Does it Make Sense to Refinance?
I see it all the time: When I am closing a purchase loan in a higher rate environment, at the closing table my client swears to me, “As soon as I can, I am going to refinance this thing!” Then a year later, when that opportunity pops up, they aren’t so sure and want to wait to see if rates get better. Let’s start with the basic understanding of how to evaluate whether a refinance option makes sense for you: compare the costs of obtaining that new loan to your monthly interest savings, and determine how long it will take for the interest you save to equal the cost to obtain those savings.
Let’s use the example of Pablo Icecreambar, who purchased his home in February of 2024 at an interest rate of 7.25% with a $400,000 dollar mortgage. Given that in the first year, most of the payments are going toward interest, his payoff after his February 2025 payment is $396,129. His closing costs on a refinance would be approximately $4000 using typical fees and Henrico County, Virginia taxes. I’m also using a pretty unexciting set of numbers. Of course if you’re saving a ton of interest, these decisions are easier, but you don’t need me around to help with an obvious decision, do you?
Graph of prevailing interest rates for the last 12 months
Let’s assume that Pablo shares with me that he’s hesitant to refinance now, because he believes rates will continue to go down. I would typically suggest a loan structure where we don’t go with the lowest rate, but instead choose a slightly higher one that provides a credit back toward closing costs, so perhaps 6.75% with a $2000 credit toward closing which would mean a $2000 total cost. Want to see how I would show Pablo those options? Click Here for the full presentation
You can see that going with a higher rate with lower cost means we come out ahead with the refinance after 13 months. The lower rate without the credit becomes the overall lower cost after 22 months. It’s up to Pablo to determine his comfort level on where he expects interest rates to go over the next year, but every month he keeps his current mortgage, he is missing out on guaranteed monthly interest savings. We can cover more on the cost of waiting next week, but it’s worth keeping in mind that it’s not free to wait and see if rates go lower.
Refinance comparison
Assuming that Pablo chooses the option which has the shorter breakeven period, given his concerns that rates will continue to drop, even if he is right and we are doing this all over again in 2 years, he has still saved $3706 in interest and paid $859 more toward principal in that time period than if he kept his current loan. If he threw his monthly interest savings from his mortgage into an index fund, at the end of that 2 year period, he would have made $277 in interest on that money as it has accrued, too. I could probably be a better salesperson and use much more impressive numbers over a longer period, but if the decision isn’t on whether to refinance at all, just now vs. later, those aren’t going to be all that helpful. Who cares what it looks like in 20 years, Pablo probably won’t still have any of these loans regardless, statistically speaking.
I would do a lot of things to save $4842 - frequently the underwriting process is easier on a refinance since there is not the added moving part of a property transferring from one party to another, and you can more often receive an appraisal waiver to further reduce cost and effort. To me, an hour or so of gathering documents and another hour of signing paperwork is a great return on investment for even pretty moderate savings on this loan option. Is it to you?
