Question: After months of watching the rates, I decided to refinance my $300,000 mortgage to 6.125 percent. This rate was a lot higher than the ones I see advertised but my mortgage broker convinced me that a higher rate with no points or closing costs is better than locking into a lower rate that carries all kinds of fees and points. Do you agree?
Answer: Absolutely. It appears you have a knowledgeable mortgage broker. The only way it makes sense to refinance to a lower rate that carries thousands in fees and points is if you hold the loan long enough to recoup the costs. The problem is that many folks don't realize how long it actually takes to pay back the costs in the form of a lower payment. Let's do some number crunching.
The principal and interest (P&I) payment on a $300,000 loan at 6.125 percent is $1,823 per month. With today's rates, you should be able to refinance a $300,000 at this rate and avoid paying any costs. Your closing costs should be wrapped into the higher interest rate, not rolled into the loan amount. Dropping the rate one percentage point to 5.125 percent would result a lower P&I payment of $1,633, but would carry significant cost. In Virginia for example, standard closing costs would total perhaps $2,300.
But 5.125 percent is a "discounted" rate, so lenders will charge points. In most areas, expect to pay up to three points for a 5.125 percent rate. Since one point is equal to one percent of the loan amount in cash, the total points would cost you $9,000.
Add the closing costs to the points and your total cash outlay in order to get a 5.125 percent rate is $11,300.
So the bottom line here is that you can pay $11,300 in order to drop your rate by one percent. This drops your payment by $190 per month.
Divide $11,300 into $190 and we find that it will take 59.47 months to recoup your costs in the form of a lower mortgage payment. That's five years. So looking at the surface, one might think that if you plan on holding the loan for more than five years, you should fork out the dough and get the lower rate.
The problem is that this is an inaccurate method to calculate your "recoup time". Remember that mortgage interest is deductible on your tax return and you pay more interest at 6.125 percent than at 5.125 percent. In fact, my calculator tells me that over the next five years, you would pay $14,982 in more tax deductible interest at the higher rate. Assuming a 28 percent tax bracket, this would mean you would pay $4,195 less in taxes to Uncle Sam. Divide that number by 60 months, and you see that your monthly tax savings is $70.
Since you save $70 in taxes taking the higher rate, we must subtract is from the difference in P&I payments. $190 minus $70 is $120 per month. This is the real difference in payments between 5.125 percent and 6.125 percent. Divide $120 into your cost of $11,300 and your new recoup time jumps to 94 months, or about eight years.
But wait, there's more. These calculations assume a loan amount of $300,000 in both scenarios. In other words, you need to come up with the $11,300 in cash. I realize that the markets aren't doing very well these days but it's probably safe to say that over five years or more, your $11,300 could probably earn a minimum of three percent per year. That's an extra $339, or $28 each month that you can't earn if you throw the money away in points and closing costs. Subtract $28 from $120 and your new difference between 5.125 percent and 6.125 percent drops to $92.
$11,300 divided by $92 is 123 months, or 10.25 years. That's an awful long time to wait before you recoup your costs. In order for the lower rate, high cost loan to make sense, you have to be absolutely certain that you're going to hold the loan that long. Otherwise, you have lost money. And statistically, people don't hold loans for more than about five years. They refinance, move or otherwise pay off the loan.
You're mortgage broker gave you good advice. Take the higher rate and avoid giving the bank a giant up-front fee.