How Do You Know If You Should Refinance Your Mortgage?

For those who hold a current mortgage, just a quick note that interest rates for conventional fixed rate mortgages have dropped again to historically low levels. As a result you should compare your current mortgage with other alternatives available to see if it makes sense to refinance.

How can you tell if it makes sense to refinance?

The way I approach this is to determine the net present value of the current mortgage payments over the remaining lifetime of the loan. Then I calculate the net present value of the mortgage payments if you refinanced. If you pay the closing costs out of pocket (these are costs outside of escrow items such as insurance and real estate taxes that you would need to pay anyway in the future), then you add this dollar value to the net present value of the refinanced mortgage payment. Whatever payment has the lowest net present value is the option that you should choose. Of course if it favors the refinance, but the difference is not material in nature, then it may not be worth the time and aggravation to refinance.

The traps I tend to find is when people only take the closing costs and divide it by the monthly savings to determine a breakeven point to make the decision on whether to refinance. This isn’t a trap by itself, but it is a trap if they extend their mortgage and fail to take into account the extension of payments beyond their current mortgage that they now have to pay. Also it doesn’t tend to pay off if you plan to move within five years.

About the author

Jeffrey N. Bogue, CFP®

4 Comments

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  • The below is intended to be generalized thoughts and experience that I have had as a planner. It is not intended to be advice as I would need to know your values, goals and circumstances better to make an accurate assessment. With that, here are my thoughts:

    Dee: From what you described, your issue goes beyond the refinancing issue, it sounds that the issue involves the lack of communication between you and your husband surrounding your finances. And as you alluded, refinancing may just provide the opportunity to get into more debt. Given that your mortgage refinancing wouldn’t be as advantageous due to your credit record, you may want to put refinancing on the back burner and that you and your husband focus on communicating more effectively with one another and setting a budget to stay within your means first.

    Carmela: Ultimately the strategy depends on your overall goals. Paying off a mortgage in most cases is economically similar to investing in a money market account. If your retirement portfolio doesn’t require any more than a cash equivalent rate of return to meet your long term retirement needs, then it would suggest that paying off the mortgage is viable. But I will find that not many people in my experience can afford the luxury of paying off their mortgage with assets that have the potential to grow and meet your inflation adjusted spending later in life.

    Also, taxes throws a curveball in this as taking out the money to pay off the mortgage will most likely put you in a higher tax bracket where you would normally be in a lower marginal tax rate. Paying 10%-20% more (not including state taxes) is very costly and takes money out of your pocket for the long haul, furthering the risk of running out of money during your lifetime. In some cases, rather than paying off a mortgage all at once with tax deferred retirement funds, I recommend accelerating your mortgage payments in a manner that allows one to remain in their current marginal tax bracket, but speeds up the time frame where the mortgage is paid. Of course this would only make sense if the person could afford to make this move as described as above (essentially don’t need growth in their retirement assets to meet their needs.

  • I have an IRA with a value of approximately $192,000 right now. In addition, I have a tax shelter of approximately $50,000, a 401K with a value of approximately $40,000, and a pension of $2700 per month. When I begin receiving social security (2012), I will get approximately $2084 monthly. My current mortgage is $205,000 and I am considering refinancing. My question is this. Is there some way I could roll over the IRA to pay off the mortagage (either all at once or use it as a draw monthly against the mortgage payment) without incurring a large tax hit. Is this even a good idea? My thinking is that my mortgage would be my biggest debt when I retire, so if I could eliminate that debt, I would have the other remaining sources of income to handle all my other debts. My current mortgage is about $1735 monthly and I plan to retire by December 2012.

  • Jeff,

    For nearly eight years my spouse has been wanting to refinance our home for several reasons:

    1) To pull equity out of the home to pay-off bills that I have little knowledge about. On several occasions I have ask to see the bills that need to be paid-off, but my spouse refuse to reveal and openly discuss the outstanding debts.

    2) Now, it is to refinance our home at a lower interests rate to have a lower mortgage payment. Which I really do not have a problem with. However, we have been down this road before to pay off debts, but somehow “one of us” ends-up traveling this road of “debt” again.

    My main concerns at this point, is that we may not received the best quote for an lower interests rate due to current credit score, high debt to credit ratio, and history of late payments for other bills that I have not knowledge of. Please advise.

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