Refinancing: Fees/Taxes Versus Interest Rate Savings

In an environment where mortgage rates are falling (as they are now), the urge to refinance can be extremely tempting. Provided you do your homework and make sure that the savings outweigh the costs, refinancing can be financially beneficial. But how can you ultimately determine whether this is the case?

Unfortunately, there is no magic formula. The most thorough calculation would mimic the approach used by institutional bond issuers, who typically seek to achieve 1% in net present value savings before committing to refinance. In other words, it makes sense for them to go through the (relatively complicated) process of refinancing only if new debt service (i.e. interest, principal, fees) is at least 1% less then old debt service, in present value terms (i.e. after discounting future payments to adjust for inflation).

While such an involved approach is hardly appropriate for the average homeowner, I think it nonetheless represents a good starting point both because it touches upon the variables that must be factored into a decision to refinance, and also because it underscores how complicated such a decision actually is.

Most experts simply use the “2% rule” as a basis for weighing a mortgage refinancing. Simply, if you can shave off 2 percentage points from your current mortgage interest rate, a refinancing will almost certainly save you money. This 2% figure is a bit inflated in order to account for the (sometimes significant) fees and taxes associated with refinancing. Ultimately, it’s a reasonable benchmark but not a hard-and-fast rule, and it’s still essential that the calculation is tailored to your specific situation.

The purpose of this calculation is to determine how long it will take you to break even. For example, if refinancing will save you $100 a month but will cost $5000 upfront, it will take four years ($5000/100 = 50 months) before you can can begin to realize actual savings. If you’re “lucky,” these costs will already be amortized into the mortgage (reflected in the form of a higher rate), and you can simply compare your old monthly payment with your (hopefully) reduced new payment.

When calculating costs, it can sometimes be tricky to determine what to include. Costs such as prepaid interest, real estate tax and insurance escrows may “go toward paying your expenses down the line” and “you should probably exclude those expenses from the calculation.” On the other hand, you need to factor in mortgage taxes, which can be significant. “Borrowers who refinance can sometimes avoid the tax if the lender agrees to treat the new loan as essentially an extension of the old one. These so-called ‘consolidation and extension’ arrangements have been harder to arrange recently, however.”

The savings calculation is further complicated by the fact that a refinancing almost always results in a longer mortgage (i.e if five years into your original mortgage you refinance your 30 year mortgage for a fresh 30 year mortgage, the result is that you will now have to make payments for another 30 years rather than the 25 years left on your original mortgage). This can artificially inflate monthly savings because they are spread over a longer time period.

One columnist, therefore, suggests that you “ask your loan broker to compute the amount you would pay per month if your new loan actually had to be paid off in full on the same date as your existing loan. When you have both numbers computed to the same end date, you’ll be able to compare the actual amount you’ll pay monthly on an apples-to-apples basis.” Another solution could be to refinance into a mortgage with a shorter term (i.e. 30 years to 15 years), which under the right circumstances could result in comparable monthly payments, but for a shorter time period.

Finally, since mortgage interest is tax-deductible, lower monthly payments will actually result in an increase to your tax bill. You should adjust your savings calculation accordingly.

In the end, your potential savings should be viewed against the terms of your new loan. If you are reasonably certain that you will remain in the same home for the duration of your (new) mortgage, a refinancing will probably save you money in the long term, even if it takes a few years to break even with upfront costs. On the other hand, if you are already 10 years into a 30 year mortgage, it probably doesn’t make sense to refinance, unless interest rates or your credit profile have changed significantly in the meantime.

If you’re on the fence, here’s one last option to consider: “What if you take the amount you’d pay in loan fees and use it to prepay your mortgage?” Since, “You only get charged interest on the amount you borrow…if you prepay the balance due, you’ll save yourself the interest charges on that money. It really adds up over the years.”