The minutes for the September Federal Reserve board meeting revealed some compelling information: the decision to not raise interest rates was a “close call.” This has brought a lot of speculation that mortgage interest rates may be on their way up.
In anticipation of an increase in rates, the yield for long-term treasury bonds has risen. Historically, the yield for long-term treasury bonds has been an indicator of mortgage interest rates (yields increase, mortgage rates increase).
Mortgage rates are still low, however expectations are for mortgage rates to increase once again. After all, our economy has recovered since the Great Recession. This begs one question: should home-owners refinance now to take advantage of the low rates before it is too late?
The answer is not a simple one.
One thing that I tout is that people should purchase a home on a mortgage only when their personal circumstances can warrant it. You should never let external market conditions guide your personal financial decisions.
The same goes for refinancing – it should only be done if your personal circumstances warrant it; do not make a generalized decision based on macro-economic factors.
How to determine whether or not a mortgage refinance is a good idea.
Luckily, there is some simple math that we can use to judge a mortgage refinance. The analysis that we use is a “break-even analysis.” Follow me through this example…
Let’s say that Johnny has a mortgage that is currently at 6.00% APR. Johnny is considering refinancing the mortgage for 3.50% APR. The mortgage value is currently $100,000 and the mortgage refinance term will be 15 years. The closing costs on the refinance are $5,000.
First, we determine how much interest would be saved by refinancing. Using simple math, Johnny calculates this as $100,000 X 2.50% (the difference between 6.00% and 3.50%). This equals $2,500 per year.
Please note that I ran amortization schedules and found the actual savings to be about $2,383. The simple math calculation was not too far off!
Secondly, we determine our “break-even” point. This is the point in time where the savings on interest equals or exceeds the closing costs.
Think of it this way…
When you refinance, you have to pay closing costs. Think of the closing costs as your up-front investment. By doing a break-even analysis, you want to determine how long it will take for you to make your money back. How long will it take before the refinance “pays off” and you actually save money.
Based on the simple math figure, the break-even point is in about 2 years (24 months). Based on my amortization schedules than were run, I found this point to be 2 years and 4 months (28 months).
What does this mean?
If Johnny refinances his mortgage, then he needs to stay in the house for at least 28 months before the refinance has “paid off” and he has made his money back. If he sells before 28 months are up, then he loses money on the deal.
Please note that my numbers are not necessarily reality. In fact, the closing costs in my illustration may be low or may be grossly exaggerated. Really, it all depends on location and personal circumstances. On average, break-even points on mortgage refinances are right around 2 years.
Ultimately, the math is what I want to point out here. This is the process that we can go through to judge the viability of a mortgage refinance. The same math (break-even analysis) could be used in a variety of applications:
- Other debt refinancing
- Dropping comp/collision on auto insurance
- Purchasing cell phone insurance
- Capital expenditures for businesses
The break-even analysis is a powerful tool in your financial repertoire.
Above all, be sure not to make generalized financial decisions based on market conditions and what you hear from the media. Make educated decisions that make sense for you in your situation. Personal finance is PERSONAL, after all.