Despite the recent increase in the growth rate of the economy, interest rates remain stubbornly low. Many mortgage borrowers who to this point have procrastinated in making a refinance decision are wondering whether the market fates are giving them another shot. And some who did refinance earlier are wondering whether they ought to do it again. A critical question for these borrowers is the degree of certainty they can have that a refinance will provide a net benefit. This article discusses three approaches to that question that have emerged over the years, and a new approach introduced here.
Prior to the new approach, the one that came closest to providing complete certainty of a favorable outcome is to refinance with a no-cost mortgage (NCM). A NCM is one on which the lender pays the upfront costs in exchange for a higher interest rate. If that rate is nonetheless below the rate on the borrower's existing mortgage, the refinance is a winner. You don't need a calculator to determine that, only the certainty that you are getting a true NCM on which the costs are being paid by the lender.
There is some ambiguity, however, about which costs are covered. A lender may not include tax escrows and/or homeowner's insurance in a NCM because you must pay those whether you refinance or not. Alternatively, these costs may be covered at a higher rate. Note also one cost you can't avoid, which is paying interest on two loans for a few over-lapping days. That charge, however, is small enough to be disregarded.
While the borrower obtaining a NCM at a lower rate can be sure the refinance provides a net benefit, borrowers intending to be in their house for a long time might benefit even more if they paid upfront costs to reduce the interest rate. The problem is that in negotiating two prices instead of one, they are vulnerable to being overcharged. On my web site, I explain how to shop for competitive offers in this situation.
The Break-Even Approach
The most common approach to determining whether a refinance will be profitable is to calculate a "break-even period" (BEP) by dividing the upfront cost of the new loan by the reduction in the monthly mortgage payment. The loan officers who use this approach tell their clients that if they are reasonably certain to retain the new mortgage past the BEP, the monthly payment savings will exceed the cost, and therefore the refinance is a winner.
Don't believe it. While this approach is easy to understand and the calculation is simple, it does not take account of changes in the loan balance, interest loss on upfront and monthly charges, and tax savings. Furthermore, on transactions in which the term of the new loan exceeds the period remaining of the existing loan, which is the case when the borrower refinances into a loan with the same original term, the BEP approach has a systematic bias toward making the refinance look more profitable than it is.
To fill the need for an approach that took account of all the factors that affect the profitability of a refinance, Chuck Freedenberg and I a few years ago developed a set of refinance calculators that did exactly that.
Detached Refinance Calculators
The calculator Refinancing One FRM Into Another FRM on my web site allows users to take account of all the factors that affect the profitability of refinancing a mortgage. These include differences between the old and new mortgage in the loan balance, lost interest, tax savings, and mortgage insurance. This calculator assumes that you have only one mortgage and you don't take any cash out of the transaction. Other refinance calculators are available on my site for borrowers who have a second mortgage or want cash from the transaction. Many other web sites also have refinance calculators, and while some of them use the BEP approach, others are well designed.
All these calculators, however, are "detached" in the sense that the user must input the terms of the new loan. If the user does not know the kind of deal she can obtain in the new loan market, the usefulness of the calculator is limited.
Integrated Refinance Calculator
Recently, my colleagues and I completed the first and only refinance calculator on the internet that is integrated with a loan pricing network. This calculator uses live price data provided by 6 competitive lenders to find the cost of each type of new loan, and for users looking to refinance, it finds the exactly comparable cost of retaining the existing mortgage. Hence, this calculator does not rely on guesswork for the terms of a new mortgage. Further, it tells the user not only whether the refinance would save money, but also the type of new mortgage for which the savings will be the largest.
For more information and advice on refinances or mortgages in general, you can contact the professor at The Mortgage Professor.