Mortgage Refinance and Resetting the Clock

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The following is a guest post from reader TFB, who blogs anonymously at The Finance Buff where he covers investing, taxes, banking, mortgage, insurance, and other personal finance related topics. You can find more of his posts about mortgage refinances under the “refi” tag.

I refinanced my mortgage recently. The rate on my 15-year loan went down from 4.25% to 3.75%. With a lender credit covering the bulk of my closing cost, I spent about $200 on a refinance that will save me over $1,000 interest every year.

Some people don’t like to refinance their mortgage even when the rate is lower and there’s no fee, because they fear it’s going to reset the clock for the eventual payoff. They reason that when they refinance to a new loan, the payoff date will be extended, and they will end up paying more interest over the life of the loan than they would if they didn’t refinance.

In some cases it’s true. For example, if you are five years into a 30-year mortgage at 5.25% with $200k principal balance remaining, keeping the current loan at 5.25% for another 25 years will cost you additional $159,384 in interest. Refinancing the $200k principal balance into a new 30-year loan at 4.5% will push out the payoff date by five years and cost you $164,813 in interest in 30 years. By refinancing, you end up paying more interest.

  Old Loan New Loan New – Old
Principal Balance $200,000 $200,000 $0
Rate 5.25% 4.5% -0.75%
Years to Pay Off 25 30 +5
Remaining Interest $159,384 $164,813 +$5,429

It doesn’t have to be that way.

The reason you will pay more interest over the life of the new loan is because you are paying less toward principal in the new loan. Under the old loan at 5.25%, you pay $1,199 a month. Under the new loan at 4.5%, you only pay $1,013 a month. In the first month after refinancing, although the interest is lower by $125, you will also pay $61 less toward principal.

  Old Loan New Loan New – Old
Monthly Payment $1,199 $1,013 -$186
  Principal (first month after refinance) $324 $263 -$61
  Interest (first month after refinance) $875 $750 -$125

There are several ways to deal with this problem.

1. Refinance to a Shorter Term

If you refinance to a 20-year loan at 4.25% instead of a 30-year loan at 4.5%, the loan will be paid off sooner (in 20 years instead of 25 years). The monthly payment is only slightly higher. You will pay $1,238 a month instead of $1,199 a month. Paying $39 a month more will save you more than $60k over the life of your loan.

  Old Loan New Loan New – Old
Principal Balance $200,000 $200,000 $0
Rate 5.25% 4.25% -1.00%
Years to Pay Off 25 20 -5
Monthly Payment $1,199 $1,238 +$39
Remaining Interest $159,384 $97,233 -$62,152

Here you are pushing 100% of the interest savings plus a small extra amount per month toward paying down the mortgage. That’s why it will be paid off faster.

2. Make the Same Payment

What if you can’t or don’t want to pay extra $39 a month? You can still refinance to a new 30-year loan, but make the same monthly payment as before. Because the interest rate on the new loan is lower, more from the same monthly payment goes toward principal. The new loan will be paid off in 22 years instead of 25 years.

  Old Loan New Loan New – Old
Principal Balance $200,000 $200,000 $0
Rate 5.25% 4.5% -0.75%
Monthly Payment $1,199 $1,199 $0
Years to Pay Off 25 22 -3
Remaining Interest $159,384 $114,636 -$44,748

With no change in your monthly cash flow, you are able to save a substantial amount of interest by refinancing.

3. Catch Up on Principal

You see in the previous example you will be able pay off the loan in 22 years instead of 25 years if you keep making the same payment as before. If you’d like to maintain the original 25 years target, you can pay less than what you paid before but more than the required monthly payment on your new loan.

  Old Loan New Loan New – Old
Principal Balance $200,000 $200,000 $0
Rate 5.25% 4.5% -0.75%
Monthly Payment $1,199 $1,013 -$186
Extra Monthly Payment   $99 +$99
Years to Pay Off 25 25 0
Remaining Interest $159,384 $133,364 -26,020

How do you know how much extra to add to the required monthly payment? You use the PMT function in Excel. The monthly payment to pay off $200,000 in 25 years at 4.5% interest rate is $1,112:

=-PMT(4.5%/12, 25*12, 200000)

The extra payment required to pay off your new loan in 25 years is $1,112 – $1,013 = $99.

If you are concerned the bank won’t credit your extra principal payment correctly if you just include it with your mortgage payment, you can make a special principal payment once a year, with a paper payment coupon if necessary. In our example it will be $99 * 12 = $1,188.

I made a spreadsheet for these calculations. Plug in your own numbers and see how they come out. Don’t let the fear for resetting the clock stop you from refinancing to a lower rate.

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  1. In all of your examples, I’m surprised that you have not added the option of a no cash-out refi. All of the options above assume a refi for the same amount as the original principal of the loan… Assuming your loan was a standard loan, you would have paid down principal in those 5 years of holding the loand. Therefore, the old loan balance, even though it started at $200K, would now be in the neighborhood of $180-190K. Run the math on that option; you can have lower payments and not pay the same overlap of cumulative interest.

  2. Great post and thanks for the spreadsheet. I’d like to know how you were able to re-fi for only $200. That is the part I need a post on.

  3. Frankie – Agreed! We looked into it last year but the costs were all over $3000, which we wouldn’t have recouped by the time we are planning to move next spring.

  4. 3.75 is excellent. can you let us know who your lender is?
    I am also at 4.25 at 15 years currently.

  5. If you go to his home blog he has a whole slew of posts on what bank he used and how he did it. Although how he got the $700 lender credit I’m unsure of. I’m getting a pretty good quote from his bank (First Internet Bank) for 30yr 4.25% with $650 in closing costs on $400K loan.

  6. Many lenders will offer you a credit against closing cost if you agree to take a rate that is slightly higher than the rate without the lender credit. Therefore there is always a rate at which you can refinance without a substantial closing cost. The refi decision comes to two steps:

    1) What’s the no-cost rate? If it’s lower than your current rate, you should refinance. This is covered in this post.

    2) How much lower a rate can you get if you agree to pay the closing cost? That’s a tradeoff between rate and closing cost. You use the calculators I included in that post to decide which way to go.

    Now, specifically to the bank I used, First Internet Bank, if you choose the next higher rate than the highest listed, you will have zero or negative closing cost. For example Frankie got a quote for $650 closing cost at 4.25%. If he chooses a 4.375% rate, the closing cost will be completely covered by the lender, possibly also leaving some extra to offset prepaid interest and escrow deposits. You will have to call to find out how much credit you will get if you choose the next higher rate.

  7. Good post. It drives me crazy the number of articles I see which say not to refinance due to high closing costs (when there are plenty of no-cost refinances available, or ones at low cost like you mentioned), or where people say it costs in the long term due to extending the loan (when as you say, you could just make the same payment as before and actually save a lot over the long term with the lower rate). Finally an article which acknowledges these things!

  8. We just refi’ed into another 30 year mortgage. We were 4 years into the original mortgage and are making the same payments. As a result, our total payoff time will decrease to 24 years.

  9. Thanks for the clarification. I’m actually moving forward with an application at First IB and will watch the rates over the next few weeks. I believe I’ll save $200/mo which would pay for itself in just over 3 months. First IB did tack on a hefty insurance charge into escrow that is &X over what I pay now for insurance, so I hope that will sort itself out as we get serious.

  10. @The Poker Meister – The principal balance in the examples is the remaining principal balance, not the original principal balance. All the examples are no cash-out refi’s.

  11. the FIB rate seems too good to be true and they had a lot of negative reviews on various websites. did that concern you before you went ahead with them?

  12. @sg – Working with a vendor I had not used before is of course a concern. But because I don’t have to pay anything until I lock the rate and receive a GFE with the lock clearly stated, I don’t stand to lose much. I took a chance based on other people’s positive experience and it turned out well. I had no problem whatsoever. My refi was done on time. The final cost was actually slightly less than originally quoted. A friend of mine also closed with First IB a few days after I did. He had similar positive experience with them.

    I don’t consider their rate “too good to be true.” It’s a fair rate. They still make a few thousand dollars from doing it. If other lenders’ rates or fees are higher, it only means those other lenders want to make much more from doing a refi.

  13. I am 2.5 years into my mortgage. I put down 20% on a 232,000 house. My original rate was 5.25, but I got it down to 4.75 at the same bank a year ago or so by paying a small fee (no refinance). I have every reason to believe I’ll be living in this home for a long time.
    I like that my current bank is a small community bank and they’ve been easy to work with. Can anybody give me a reason why I shouldn’t refinance into a new 30 yr at first internet that’s a 4.0 rate with a few thousand in closing fees besides that it would be more work than doing nothing?

  14. @Dave – If rates drop again, your a few thousand in closing fees will go wasted. That’s the trade off between rate and fees I mentioned in a previous comment. Doing a 4.125% with no fees will preserve your option to refinance again.

  15. Thanks TFB. I can’t do a 4.125% with no fees though. Closing costs are rather high where I live. Probably more like 4.37. I’m mostly wondering if there are positives to having a small well rated local bank beside the feeling good about supporting community part.

  16. Wells Fargo offers a no fee (ZERO) refi….I did it last year with them and I just checked their web page…they still offer it… current wells fargo loan folks….I actually got a letter in the mail last year about it….the deal was so sweet I tried to do it again this week to lock in these great rates….no luck since I did my refi less than a year ago…..took out a new 15 year loan and kept making my old loan payment and added to it a bit….new pay off is in 12 years….right when I retire.

  17. Frankie Says:
    October 13th, 2010 at 10:00 am
    If you go to his home blog he has a whole slew of posts on what bank he used and how he did it.<–who's home blog are you talking about? Great timing on this, btw, as I am looking into this right now. Appreciate the legwork!

  18. There are two things I need to mention here. In most cases, you can have the mortgage as long as you want. If the mortgage offered is 30 years mortgage, you can choose to have it for 27 years.

    Secondly, even though you pay more interest over the life of the mortgage, cost of using banks money goes down. You pay for keeping the money little bit longer. However, when you refinance, for the initial years you pay mostly interest. Somehow, calculations make sure that you do not pay much capital for the first two years.

  19. Great stuff

    I had always understood the concepts outlined here, but having them staring me right in the face with raw numbers to back it up makes it very striaghtforwrad.

    Thanks TFB!!!

  20. I just got 3.375% on a refinance at ING Direct for ~$1300 in closing costs. I will break even after ~9 months.

  21. @TC – Break even should be calculated against a no-cost loan, not against your current loan. For example if you can get the same loan elsewhere at 3.5% with no closing cost, the $1,300 for 3.375% really just buys you 0.125% in rate reduction. The break even time will be much longer than 9 months.

  22. Also, those ING Direct loans are 5-7 year ARMs. Those are oranges, we are talking about apples in this post.

  23. Thanks for the spreadsheet, it is very useful!

    You do have an error with your spreadsheet for cell
    B13 and B14 where is not not relative to numbers being entered.

  24. @plin – I’m guessing you are saying cell B12 is not used in any calculation. I made a change in the spreadsheet to make it clear.

  25. Awesome post TFB. I have locked in 3.375 no closing/no escrow loan (5/1 ARM).

    With current rates, I’m willing to take the risk and go back to fixed rate after 4 to 5 years or refinance if rates drop less than 3.375%

  26. I have a 5 percent loan with 28 years to go. I could refinance today with Penfed at 3.875 with no points. Why should I? I am only staying in my house for ten years more. If I want to pay less interest why don’t I just pay more principle every month. I don’t want to go back to 30 years if I reset. I am not doing it.

  27. Good post!

    I’ve always been a little unconventional in just doing an amortization schedule with new rate, plugging in old payments (Extra principal) and seeing if I could pay the loan off faster than current amortization. If so, the refi make sense. (I generally have to get a 1% reduction or save $200/month to make it all worthwhile. I wouldn’t do it to shave off just a few months, of course!) I am still early enough in that a 30-year still makes much more sense than a shorter term. Of course, you have to factor the closing costs too. We refied down to 5.75% in 2003 & 4.875% in 2008. Instead of making extra principal payments, we have decided to beef up retirement with the $400/month savings. I would LOVE to refi to a 15-year at current rates, but just don’t want to commit to the payments. We just aren’t there at the moment. But, it’s definitely tempting.

    We have never done a cash-out refi and tend to pay cash for closing costs. I find it funny the impression by very conservative friends that we are a little “refi happy.” I am sorry, but I had 25 years left on my mortgage. Why on earth would I want to pay an extra 1% for 25 more years??? (What they don’t know is that we plan to pay off our mortgage in about 12 more years, anyway. So, starting the loan over is really the least of my concerns – just doesn’t mean anything to us since we have absolutely no intention to keep our mortgage the whole 30 years).

  28. just refinanced a rental property with ING for just over 4%. that is unheard of. i am looking to get all my rentals refinanced shortly. because of equity, i was able to roll in closing as well. rates are really low, and the fed is not increasing them anytime soon. lock them in while you can!

  29. Thanks a lot for the info – Alaska49
    “Wells Fargo offers a no fee (ZERO) refi….I did it last year with them ”

    on wells fargo web site this offer comes up as
    “Streamlined Online Refinance”

    Once you do the “streamline”, how does it show up on your credit report?

  30. Thank you SO much for cross-posting this!!

    I checked the Wells-Fargo streamlined quote, LendingTree and FirstIB. FirstIB came in at 4.125 and NO closing costs (as of today).

    Even though I refinanced last year at 4.625, this is worth it!

  31. Great post with detail examples.

    I just refinanced last year for 4.25 with a local bank Amegy and paid hefty closing cost. If I can get 3.75 with no closing cost, I would certainly do it again. Let me check it out and see my luck.

    Thanks for sharing the experience. I been planning to post my refinance experience in my blog and couldn’t get to it but would certainly refer your website to my readers.


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