At the start of the new year, I declared that one of my goals is to refinance our existing mortgage for our home. Missing the opportunity to refinance in 2020 at exceptionally low rates was even one of our big financial mistakes for the year. But I needed to answer one question before I started chasing down lenders and learning about the refinance process. Is it worth refinancing for 1 percent?
- Is Refinancing Worth It?
- What About My Own Refinance Prospects?
- What’s Refinancing Worth for You?
- Refinancing, Part Two:
Is Refinancing Worth It?
The refinance rates I’d seen around the internet were only about 1% lower than our current mortgage. I wasn’t sure if refinancing would be mathematically worth it. Not to mention all the mental load involved with going through the loan process.
Getting this task done became part of my yearly theme, which I call “discomfort”. It might sound silly to make a big deal out of it, but for me, refinancing includes a whole bunch of steps that make me pretty uncomfortable:
- The unknown. While I have a strong grasp of residential mortgages after going through our home purchase in 2013, I don’t really understand all the underlying math with regard to refinancing or the jargon related to it.
- Negotiation. From the little I did understand, I’d need to negotiate with multiple parties in order to get the best rate on our mortgage refinance. I think I’m a good negotiator (I’ve got a lot of experience selling our stuff locally), but I don’t like doing it. I wish both parties could just be honest and upfront about their “best offers”. It feels like an irrational stab in the dark to me.
- Phone calls. Jenni will attest that one of my least favorite activities is talking on the phone. I greatly prefer an in-person discussion to read body language and clearly understand intentions (and communicate my own!). Email or text is second best with phone conversations far at the bottom.
And so, the “mortgage refinancing project” easily fell into my discomfort theme. It’s come up on my personal updates in my theme progress within our monthly budgets. I’ve also kicked it down the road multiple times.
I am a procrastinator. Sigh.
But not today! I’ve finally made progress! I want to share some of the financial calculations I’ve run during the mortgage refinancing process, the mindset I’ve developed, and some of the strategies behind my decisions.
I’ll also show you how to do your own calculation to determine whether or not it’s worth it to refinance given your current mortgage interest rate and the refinance rate available to you.
When should you refinance?
The very first question I asked myself was: what’s the trigger that should cause one to refinance their mortgage? As I understood it, one could refinance at any time. So what precisely is the thing that gets people to do it?
I think the answer is saving money. But could I even save money in the long term refinancing?
First, let me layout our original mortgage:
- Purchased our house in spring of 2013
- $229,500 purchase price
- 20% downpayment
- $183,600 loan
- 3.625% interest rate
- 30-year fixed-rate loan
In fact, here’s the Good Faith Estimate (GFE—similar to a Loan Estimate or LE):
Working from this 30-year term and 3.625% interest rate, I had something to compare to today’s interest rate environment.
It’s pretty easy to find general refinance offers out on the Internet, though rates that are advertised—I think—are misleading. They often include pre-payment of part of the loan through “points” and are available under ideal circumstances.
Rather than working from these idealized rates, I think it makes more sense to look at averages. Just like with investing, my goal isn’t really to beat the market by picking individual stocks as an investing wizard.
I want to know what the average is and see if that’s good enough for me. Then, I can go live my life!
What’s the current competitive rate?
So, how do we find average mortgage rates?
As usual, FRED’s official government data makes it nice and easy. They’ve got a dedicated page for 30-year fixed-rate mortgage averages:
We lucked out in 2013 by capturing close to the lowest rate up until that point. The mortgage lending process was difficult since standards were a little tighter than today and we ended up putting our entire loan on my name (and with my business income solely). The lender ended up doing a lot of digging into my business affairs, despite me showing enough accessible assets to buy the house in cash if we wanted to.
Let’s zoom in a little on this year to see what sort of rate I should be aiming for:
In recent weeks, average rates have been a tiny bit below 3%. Working from our existing mortgage at 3.625%, I wondered if all the effort (and potential costs) would be worth 0.625% in savings.
A general rule of thumb for refinancing… is to ensure that you’re cutting your rate by 1% or more to make it worth it. This helps cover the cost of the refinance itself and your effort to get it done.
But what’s the “of thumb” part? Where doesn’t this rule work?
What’s a 1% interest savings really worth?
1% interest isn’t always worth the same thing. Well, at least, in relative terms. Cutting a 15% mortgage rate to 14% won’t make as big of a difference as taking a 2% rate to 1%. The latter will cut your interest payments in half (all else being equal)!
Let me illustrate this with a little math and show why it matters.
- Loan amount: $300,000
- Terms: 30-year fixed rate, 15%
The monthly payment would be $3,793 ($3,750 is interest in the first payment).
If we simply adjust the interest rate to 14%, the monthly payment becomes $3,554 ($3,500 is interest in the first payment).
The 1% cut reduces our first interest payment by $250.
Let’s take the example to the other extreme with a 2% rate; given:
- Loan amount: $300,000
- Terms: 30-year fixed rate, 2%
The monthly payment would be $1,108 ($500 is interest in the first payment).
If we simply adjust the interest rate to 1%, the monthly payment becomes $964 (and as you might have guessed, $250 is interest in the first payment).
In either circumstance—a 15% or 2% interest rate—a 1% cut is worth $250 off first-month interest payment savings.
Relative interest rate savings
We determined that cutting 1% off our interest rate would yield the same interest payment savings—$250/month. But how does that play into the total mortgage payment as a relative comparison?
As a before and after comparison in monthly payments:
- Moving from a $3,793 payment to $3,554 is a savings of about 6%
- Moving from a $1,108 payment to $964 is a savings of about 13%
If we assume that the person paying for this uses the same relative chunk of their income (say, one third) to pay for housing, the 1% rate reduction will have a much bigger impact for the person with the smaller monthly payment because in relative terms it’s a larger decrease. This is despite the fact that in absolute terms, the larger interest rate/monthly payment had the larger decrease ($239 vs $144).
What about equal monthly payments (and variable home prices?)
While I think you can see now that cuts at lower absolute interest rates have larger relative effects, this doesn’t really reveal a realistic comparison.
Most folks don’t purchase their homes (in this case, a $300K home whether at a 2% or 15% interest rate) based on the house cost. Rather, they base it on the monthly mortgage payment.
Folks tend to shop for homes based on the idea of “I can afford a $2,000/month mortgage payment”. Whatever that yields in terms of the final home price is what they shop for. It doesn’t matter if that’s a $200K or $400K home.
Let’s take a look at the math for the more realistic scenario where someone is shopping for a home (and mortgage) with the idea of wanting to spend $2,000/month on principle and interest.
Given our 15% or 2% interest rates, a $2,000 payment would afford:
- $158,200 (15% interest rate, 30-year fixed rate)
- $541,300 (2% interest rate, 30-year fixed rate)
Using the variable most people actually work from when home shopping (monthly mortgage payment), a 2% interest rate would afford someone a house more than three times more valuable than with a 15% interest rate.
Again, let’s see what a 1% cut looks look for both payment amounts, with each starting from $2,000/month:
- From 2% to 1% would yield a $1,741/month payment (13% savings)
- From 15% to 14% would yield a $1,874/month payment (6% savings)
Again, the larger relative decrease in interest (from 2% to 1% rather than 15% to 14%) has a much larger impact on the monthly payment. In fact, it’s nearly twice as effective. The closing costs for either loan (each being the same amount for the same property) should be the same, as should refinancing either one.
The point of running through these scenarios is to show you that in today’s low-interest rate environment of the last decade, evaluating whether you should refinance or not by the 1% rule-of-thumb might not be as valid.
At already low interest rates, a 1% decrease is much more valuable than it has been in the past with higher rates.
Value of freeing larger portions of cashflow
Freeing up 13% of the largest part of most folks’ monthly spending could make big changes to their financial lives. That represents about 4.3% of their total spending.
If you simply socked away those savings in broadly diversified index funds for the term of a 30-year loan you’d cover about 16% of your total investments needed to reach financial independence in the same 30 year period!
No really, here’s the math:
In this case, if we assume $1,108/month is equal to 33.3% of total spending, their annual spend is $39,888.
In order to retire, they’d need to save a hair under $1M to support nearly $40K/year in spending.
They could reach this point in 30 years with a 27.4% savings rate.
16% of 27.4 is 4.3%—the amount they could transfer from their monthly mortgage payments to investments by lowering their mortgage interest from 2% to 1%.
Getting a lower interest rate on your mortgage, even 1%, could drastically decrease how long you need to work in order to reach financial independence and consider early retirement.
What About My Own Refinance Prospects?
So, now that we have a better grasp of how interest rates affect monthly payment amounts, let’s come back to my own mortgage and today’s actual rates.
Given my current mortgage payment (principal and interest) of about $837/month on a 30-year fixed-rate mortgage at 3.625%, how much better can we do?
According to the FRED data, the average rate I could refinance to should be about 2.93%, as we established earlier.
How would that affect my monthly payment?
A $183,600 loan (where our loan started in 2013) at 2.93% would yield a monthly payment of $767 instead of $837.
That’s a savings of $70/month for 30 years.
We’re about 8 years into our current loan. We need the savings to at least pay for the expense of the refinance before the mortgage is up in about 22 years.
So ultimately, the question is, how long would it take to pay off any closing costs on a refinance with at $70/month?
What are my anticipated closing costs to refinance?
To calculate that, we need to know how much my anticipated closing costs are.
I’ll jump ahead a little and show you a Loan Estimate I received from a lender to refinance with them:
I’ve blurred out some of the costs to keep you focused on this break-even calculation. The additional blurred costs are prepayments and escrow—costs I’d experience through our monthly payments no matter what—but just ignore them for now.
By adding boxes A, B, C, and E we can calculate the total estimated cost I’ll incur to complete the refinance. These are services or fees required by our local municipality or the lender. While I can shop for the items within box C (and I will!), it’s a good number to work from to ensure it’s worth refinancing at all.
The total estimated cost to close the refinance is: $1,520.
When do I estimate to break even with a refinance?
We already determined that lowering our interest rate from 3.625% to 2.93% would save us $70/month. That’s $840/year. So that means it’ll take us 1 year and 10 months to pay for this refinance. That’s our refinance break-even. After that, the $70/month in savings are all “profit”.
So, if we were to sell our place and move out in a year, it’d make more sense for us to not refinance. We wouldn’t ever earn back the upfront costs.
However, we think we’ll still own our place for at least the next two years. So at least, at this point, it makes mathematical sense to pursue the refinance further—even with only a 0.695% interest rate delta!
Understanding refinance estimates
After reviewing what rates I should expect to find, I used a few different internet tools to gather refinance quotes. Bankrate’s refinance rates tool is one of the easiest to use and can gather results from quite a few reputable lenders. To get a general feel for things, it only takes a moment to plug in a few details (none personally identifiable).
Here’s what the tool spits out for me today with our details:
At a glance, a few things stand out:
- The lowest quoted APR (2.654%) is quite a bit lower than what FRED’s data suggests is average.
- The upfront costs vary wildly—from $0 to nearly $5K!
- The monthly cost isn’t just $70 or so less than what I’m currently paying, it’s hundreds!
Side note: I checked out Credible.com which, frankly, seems like a bit of a waste of time. Bankrate had just as many or more competitive quotes and required less information from me.
For my first point, there’s a few things at play.
- I’ve got a higher credit score than the national average which might help me earn a slightly better rate.
- The loan is “conventional” (rather than “jumbo”—which are much higher loan balances), which usually means the rate is lower.
- Rates can be regional, and perhaps our part of Virginia has lower inherent risk so rates are better than the national average.
- All but one of the shown rates are artificially low because of my second point…
For my second point, the upfront costs for all but one quote are over $3K. This doesn’t even include the Loan Estimate costs we’ve already talked about which are another $1.5K+. Rather, these costs are “points” which are pre-payments at closing on the interest of the loan. Doing this yields a little more favorable APR but at a significant upfront cost!
In fact, take a look at the last two quotes and their values for the monthly cost column. One is $609/month and the other $618/month. It so happens that they’re also the two most extreme “upfront cost” quotes.
Cutting your monthly payment by $9 is going to cost you a whopping $4,517! It’d take you an incredible 41.8 years to break even! Considering the loan is only, at most, 30 years long—you’d never break even!
Simply looking at the lowest APR or lowest monthly payment isn’t going to give you the best overall financial choice for your refinance.
For my third point, you might recall that our current mortgage payment is $837/month. Earlier, we figured out that cutting the interest rate to 2.93% would yield a payment of $767/month. But the monthly payment quotes in the screenshot are closer to $600/month!
That’s a huge savings!
That’s a change of cutting about 8% off our monthly payment to 28%!
Well, in all of our calculations earlier, we were comparing apples to apples. A 30-year loan at 3.625% or 2.93%.
In the real world, our loan has over 8 years of payments on it.
When refinancing, by default, you reset to whatever term length you’ve selected. In our case, that’s 30 years.
So while our original loan was about $186K, our current loan balance is about $151K. Refinancing will stretch the payment schedule back out to 30 years with a $151K loan.
We’re working from a loan amount that is about 20% smaller so it makes sense the payment would shrink by about 20% even if the interest rate didn’t change at all.
What about no-closing cost loans?
Some lenders offer some tricky financial math to hide these closing costs. “No-closing cost loans” give you the opportunity to take the expense of the refinance and tack it onto your loan balance.
So, in my example, I could take the $1,520 estimated closing cost and add that to the total loan amount. Really, I’d just be avoiding the upfront payment and paying it over time as part of my monthly mortgage payment (which would be slightly higher)—with interest on it to boot.
Lenders might also offer to zero out the closing costs in exchange for a slightly higher interest rate—but really—it’s the same financial math trickery. You’re just paying for it over time as part of a slightly higher monthly payment.
There’s no free lunch!
For me, rolling my closing costs into the loan actually make good sense. In my personal opinion, I’ll happily take a ~3% loan and keep that $1,520 invested in the market. I tend to compare most things to the sort of return I could earn in the stock market with a broad index fund like VTSAX or VTI over a long time horizon. And I expect them to do better than 3%.
That might not match your own mindset or investing goals, and that’s perfectly okay! Pay your loan costs upfront!
Securing our financial independence
Another way to think of it is that refinancing from 3.625% to 2.93% is worth about $19,500 towards our retirement ($70/month * 12/months/year * 25 [4% rule] – $1,520 upfront).
That’s not an insignificant chunk! It might mean a year or two less spent working to reach your own FIRE number.
For us, that represents nearly half a year of our current FIRE budget!
What’s Refinancing Worth for You?
Basically, there’s no cookie-cutter answer here. You need to do the math.
There are loads of calculators out there that’ll let you figure out the “break-even date” for a refinance. That’s usually when you’ve recovered the upfront costs of the refinance (closing costs) through monthly payment savings (reduced interest rate). I estimate that I’ll do so, given the Loan Estimates lenders have offered, in a little under 2 years.
The cost to complete a refinance includes a mix of fixed costs (appraisal, services, etc.) and relative costs based on the property value (origination fees, points, taxes, etc.). Depending on the mix of these costs within your refinance and the underlying property value, it might make sense for one person to refinance from 4% to 3% but not another.
What’s your goal for refinancing?
Before you start down the road to refinancing a mortgage, you need to define your goals. What do you want the outcome of the refinance to be?
- A lower monthly payment?
- A shorter time horizon to having the mortgage paid off?
- Take equity out of the house (a “cash-out” refinance)?
Your answer to that question will affect the refinancing terms you should pursue.
Our goals are pretty simple. We could pay off the house today without issue. And we have no trouble making the monthly payment as-is.
With interest rates as low as they are, we have no desire to shorten our mortgage by switching to a 15-year fixed-rate mortgage, for example. Sure, interest rates would be closer to 2.5% but we’d have to pay more each month. That constrains our cash flow and effectively raises how much we need to have invested to support our early retirement lifestyle without jeopardizing our safe withdrawal rate.
A 100-year mortgage?
Think of it like this:
Given the option, I’d happily take a 100-year mortgage if it was at a 1% interest rate.
That’d bring our monthly mortgage payment down to $242! In the meantime, we’d have an extra $595/month to invest (from our current $837/month payment).
In fact, a quick compound interest calculation shows that $595/month invested with a 7% annual return would reach $188K in just 15 years! That’d be enough to pay off our original loan balance!
Bring on the 100-year mortgage and dirt cheap money!
Refinancing, Part Two:
So, is it worth refinancing for 1 percent? For us, the answer seems to be an emphatic yes.
While I’ve worked through the math here using average 30-year rates, which showed a delta of 0.695%, in reality, I suspect we’ll do a little better than that and get closer to 1%. Excellent credit and a little negotiation will take us a long way.
In the second part of this series, I’ll explain how we’re reviewing Loan Estimates from different lenders. We’re weighing the choice between paying higher closing costs (mostly through lender points) to get lower interest rates versus having lower upfront costs but slightly higher rates.
I’ll also write about the underwriting process, the overall effort required to get this done, and our final tally of expected savings once the hard numbers are in.
It’s my hope that this multi-part article serves to help you make your own refinancing decisions. Please don’t hesitate to leave a comment and let us know what questions you might have related to refinancing!