The Refinancing Dilemma

It used to be that a small talk would start with the topic of weather. This month, however, it is: “How is your refinancing going?” You will bond in an instance and also find what today’s rates are. Like a circus animal that is eyeing a treat it could snatch after hard work, I motivate myself to think about refinancing by visualizing all the wonderful things I could potentially do with the money saved by it. $100 per month – an extra shopping trip, or let it accumulate to a $1,200 per year – you got a small family vacation. Wait a few years and use this for a new kitchen. Definitely worth investing a few hours to play a math game with your lender and then copy and sign the pile of paperwork.

Here are the rules of the math game:

  • you prefer to pay less than you already do on a monthly basis

  • you do not want to increase the overall sum of your payments from now till the end of your mortgage or sale of the house

  • with every year you own more and more of your home, you do not want to significantly slow this process (named equity buildup), and in fact you probably prefer to speed it up

With the rates falling so low throughout the last year, we all probably got some sense to obtain fixed mortgages. If you plan on staying in your house for longer than the fixed part of your adjustable mortgage is, you may want to grab a fixed one.

So, you have likely refinanced in the last year to a fixed rate or just a better rate mortgage. Now, rates fell again. Should you refinance? Refinance now or wait? This has been the main topic of discussions in my neighborhood, while we walked the dogs, compared whose grass is greener, or watched the kids play outside. We read some articles; we talked to our mortgage lenders; we bounced around some numbers. Here are the refinancing basics and some tricks we learned along the way. Neither of this should be taken as a direct advice but rather some food for thought.

What you would need:

  1. Call your lender to find out your current rate, how much you borrowed, how much you currently owe, and how many years you still need to pay.
    For example, say you borrowed a $417,000, for 30 years, with a fixed rate of 4.875%
    1.5 years later you still owe $407,000.

  2. If you think you may owe more to your bank than the current price of your home – beware of appraisal, the bank may not allow the refinancing. Check this before going any further.

  3. Ask your lender or shop around for the best options for your refinancing.
    For a $407,000 amount the following options may be considered this week:
    Option 1: 4.25%, 30 year fixed with closing costs of $2,600
    Option 2: 4.375%, 30 year fixed, no closing costs
    Option 3: 4.375%, 25 year fixed
    Option 4: 4.25%, 20 year fixed

  4. Start comparing your current mortgage and each of the alternative options. See my colorful table below. I used Bloomberg mortgage calculator to fill in details for each of the mortgage options.

Click on the table to open full size.

All the dollar amounts marked blue in reality are smaller than they are. Part of them is tax-deductible. See more details below.
Refinancing costs unfortunately are NOT tax deductable.
The key question in refinancing is how long you think you are likely to stay in the house. Rows 6, 7 and 8 describe a few possible scenarios. In many cases, one refinancing option is better in the short term but another on the long term.
The numbers in lines 6, 7, 8 are obtained by pressing View Report button on the Bloomberg mortgage calculator. Look at the table in this report. What you owe is your Ending Principal Balance, last column of the report.
What you paid is: (monthly payments) x 12 x (number of years).
Number in line 9 is your total payments. It is listed at the top of the report as well as inside the Bloomberg’s calculator GUI, below the monthly payments.

Now, let the math game begin:

Shall you consider refinancing? What option to choose

  • In general, the more you owe and the longer you still need to pay, the more it makes sense to refinance. Smaller interest rates shrink your interest. And in the first years of your mortgage term, 70-50% of your payments are part of the interest. Once you get to the tail of your mortgage, you are mostly paying principal and shrinking the small interest fraction by extending your payout time doesn’t make sense.

  • Shorten your term:

    If you still have a large chunk of your mortgage to pay, you are very likely to find a profitable refinancing option in the current environment. Compare each of the candy-shop colored columns with the yellow one (your current mortgage). Note row #4 (monthly payments amounts), row#5 (number of years to pay) and #9 (total accumulated payments). If you are doing well financially right now and can afford paying a bit more monthly, you can get advantage of the low rates and shorten your mortgage term. In our table these are last Pink and Grey options. Look how significantly it saves us in the example on a long term: $150,000 before tax! Monthly payments are higher but many people get part of them back in taxes. The actual payment difference is: (Payment difference) x (1 – tax rate)
    In the example, if we assume 28% tax bracket, the actual payment difference between yellow and grey options it is:
    ($2,520 - $2,206) x (1 – 0.28) = $314 x 0.72 = $226.08

  • Save monthly and in the accumulated payments:

    If you are struggling financially, you can use advantage of the low interest rates and refinance with the same or slightly longer term, reducing your monthly payments. In many cases, it will reduce your total accumulated payments as well. In the example, these are options green and orange, 30 year fixed rate with and without closing costs.

  • No closing costs vs. closing costs options:

    The no closing cost option is almost always your best bet if you are not certain you would stay in the house for the whole term of your mortgage. Interest payments are tax deductible. Closing costs are not. Closing costs are like a Costco membership fee – worth paying only if you know you will get the money back in savings throughout the term of use. What if you need to move? Life is unpredictable: job relocations, family dynamics, kids’ needs or new hobbies. You loose if you move soon after the refinance. How soon is this soon? Calculate how many years will it take for you to recover these up-front closing by comparing closing costs option to a no closing costs:

    Months to recover = Closing costs / monthly savings

    Monthly savings are = (Difference between mortgage payments) x (1 – tax rate)

    In the example, the difference between green and orange mortgage payments is $30.
    Monthly savings are = $30 x (1- 0.28) = $21.6
    Months to recover from the upfront $2,600 closing fee =
    $2,600 / $21.6 = 120.37 months (that is over 10 years)

    Only after these years you will start seeing the benefit of closing cost as compared with the no closing cost option. So, consider this option only if you certain that you will stay in your house for at least as long and if you believe interest rates won’t be falling anymore tempting you to refinance again.

  • Wrapped closing costs trick:

    If you really like your closing cost option but don’t have any open cash to pay for the closing costs, check this interesting trick: instead of paying closing fee up-front, borrow more equity and use these extra for closing costs. This Option is described in the blue column of our colorful table. If you are still able to reduce your monthly payments as well as overall accumulated payment and plan to stay long in the house – consider it. Why stay long? Because if you sell or refinance in a year or few – you will still owe to your bank these extra closing costs you wrapped into your mortgage. Therefore, this option is quite an opposite of pink and grey – instead of speeding up, you slow your equity buildup on your home.

  • Invest then pay off:

    With the interest rates so low and interests being tax deductible, you are paying very small rates on your loan. For example, on a 4.25% loan with a 28% tax rate, you would pay only 4.25% x (1 -0.28) = 3.3% interest. So, for every $1,000 bank offers you today, you would have to return only $1,033 in a year. There are those of us who are confident that they could generate much higher profits in a stock market or other investments. For them, an extra $1,000 today with a 10% profit and 20% tax rate on a long-term investment will result in an 8% profit or $1,080 in a year. So, instead of using any extra money they may have to pre-pay or shorten the mortgage term, they can profit more by investing: $1,080 - $1,033 = $47

Do your math, consult with your lender, chat with your neighbors, and pick what works best for you. All the above is not a specific advice but only points to consider. Interest rates do deviate a lot, so save your comparison tables for the future. Whether you refinance or not, remember: you just cleverly saved by doing something or deciding not to. And as soon as you start receiving those monthly savings, celebrate and treat yourself to something memorable.

Acknowledgments: I appreciate the help of our lender, Connor Shortsleeve ( and my neighbors in preparation for this article. Top image from Flckr, distributed under the Creative Commons License


  1. Ah, the refinance dilemma gets a tad more complicated and interesting if you look at variable rates. If you might only be in your house 5 years(the national average) or less and if you feel the economy is likely to be shaky for quite awhile this is for you. Compare your 30 year $407,000 mortgage 4.375 with a 5/1 ARM at current rate of 3.5%. The same numbers for a 5/1 loan would be:

    After 1 year: owe 399189 paid 21931
    After 3 years owe 382724 paid 65797
    After 5 years owe 365067 paid 109656

    The 30 year 4.375% NO closing in the 5th would owe 370305 and have paid 122425.

    The magic occurs when you take the $205 you save each month and apply it back to the principal so the payment is the same as the 30 year 4.375 loan( in this case $2032/month.

    Now the amounts are:
    After 1 year: 396689
    After 3 years 374955
    After 5 years 351647

    In the 5th year this amounts to a savings of almost $19000.

    You would of course have to refinance in year 6 and there is NO guarantee rates will remain low but the numbers are on your side. Your rate for years 6-9 would have to increase your monthly payment by more than $388.71(18658/48 months) for this scenario to lose money. This is approximately a 30 year rate of 7.34% for years 6-9. Even if fixed rates go up substantially to past 8% in year 6 you could refinance again with another 5/1 and get below 7.34 because currently the spread between a 30 Fixed and a 5/1 ARM is about 1 percentage point. This does vary so again there is no guarantee that the yield curve will be the same. I just think 5/1 ARMS provide more flexibility if you have the stomach and the credit rating to get them and stick with them even in a rising interest market.

    Another point is that if interest rates do rise this would mean the economy has recovered and your house and whatever other investments you own will have increased in value, allowing an easier borrowing climate for those with good credit.

    Dr. Neutrino

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