The Do It Yourself Refi
Our clients, Megan and Blake, recently called asking for advice on an opportunity to refinance their mortgage. I thought this was a little unusual since they had just refinanced the same mortgage nine months earlier.
Nine months ago, the result was a 30-year mortgage on $230,000 at 3.875% interest with principal and interest payments of $1,100 per month. At the time, the couple was ecstatic.
Now, their mortgage company had come back to them with an offer to lower their mortgage rate to 2.5% on a fifteen-year note. Great!
However, it came with a catch. Even though it was the same company and the same property, the mortgage provider wanted $10,000 in closing costs.
When interest rates were quite a bit higher, we typically looked for a two-percentage point drop in a refinance opportunity to make it worthwhile. However, now that rates are so compressed, mortgage companies are looking to other opportunities to restructure the debt, and possibly generate handsome fees in the process.
Refinancing a home usually costs between 3% and 6% of the total loan amount. Sometimes a borrower can reduce the upfront out-of-pocket cost by wrapping them into the loan. Although wrapping the fees into the loan sounds good, you still owe the money. As such, it is a real expense with a real opportunity cost.
As the couple discussed their situation, a couple key variables came to light.
First, their three children were now out of the house. I asked how much longer they might stay in their existing home. The couple was unsure recognizing that with kids gone, their options had changed quite a bit. They certainly didn’t have as much need for a larger home.
If you sink a chunk of money into closing costs and then move in two years, you won’t recover the closing costs. As such, you really need to think about the time needed to break-even.
Secondly, Blake works in the oil field. His company had seen good times, along with really lean times. As such, the couple realized that Blake losing his job or having a cut in pay was a distinct possibility. If either of these events happened, Blake didn’t want to be saddled with a fifteen-year mortgage with higher monthly payments.
As is often the case, if Blake loses his job due to a downturn in the oil patch, odds are that many other people will be facing a similar fate. That can make it difficult to get out from under an expensive mortgage while a major industry is suffering and many houses are on the market simultaneously.
As we discussed this, I asked the couple if they had considered a “do-it-yourself” refi?
If disciplined, you can make extra payments on your house and implement a flexible and effective refinancing. And if life circumstances change, so can change the terms of your refi, but without any closing costs.
I ran some figures for Blake and Megan. If the couple were disciplined and paid an extra $100 per month in principal, they would pay off their mortgage in 25 years. This would trim 51 months off their existing mortgage. This simple idea got their attention.
If they tightened the belt a little more, they could pay an extra $200 per month. This would pay off their mortgage in under 22 years saving more than 84 payments.
If they wanted a 15-year payoff, they would need to increase payments to $1,686. An extra $586 per month would nearly cut their mortgage obligations by half and save 170 payments in the process.
Although this got the couple excited, I also pointed out that they didn’t have to part with $10,000 in closing costs. Instead, they could invest this money to provide more of an apples-to-apples comparison.
Assume Megan and Blake kept the ten grand and invested it earning 7% per year over fifteen years. The value proposition on this $10,000 would grow to more than $27,000.
Over twenty years the opportunity cost would grow to $38,000 and after 30 years the opportunity cost would increase to $76,000.
As we walked through the numbers, Megan quickly chimed in that keeping and investing the $10,000 in closing costs would come in handy when it came to reinforcing their retirement funds.
Furthermore, they realized that paying extra principal each month effectively allowed them to refinance their property while keeping the flexibility of their original 30-year mortgage. If Blake or Megan lost their job this flexibility would come in handy. They could easily back off and make just their minimum payments.
However, if times remained good, they could pay down their mortgage while retaining a variety of financial options.
Dave Sather is a Certified Financial Planner™ and owner of Sather Financial Group. His column, Money Matters, publishes every other week.