# Abstract:

One of the common reasons people refinance a mortgage is to get a lower interest rate. Purchases and Refinance mortgages generally have the same interest rates – you do not pay a higher or lower rate just because you are refinancing. The interest rate you pay is determined by several factors (bank, credit score, DTI, LTV and whether you have additional points on the back end). Rates fluctuate over time due to market forces, so refinance rates may be lower then they were when you purchased, thus creating an opportunity to save some money.

# Example:

We first consider the mortgage four years and calculate the interest earned.

Using A = P (1+R/100) ^n, where A= the amount, P= the principal, R= the rate and n=the number of years.

P = \$100000

R = 12%

N = 30 years

If the loan goes to maturity of the 30-years, the borrower will pay \$370,300.53.

Now we are to calculate A so that we can determine the interest charged on the mortgage.

A = 100000 at 12% for 360 months

A = 100000(1.12) ^30

A = \$270,300.53 interest paid.

Then we, calculated by getting the difference between the amount and the principal. This

will give us the interest.

Interest = amount – principal

Interest = 270,300.53, principal – 100000

= \$370,300,53

We now consider the new loan whose interest has dropped.

P = \$100000

R = 10%

N = 25

A = 100000(1+10/100) ^25

A = 100000(1.1) ^25

If the loan goes to maturity of the 25-years the borrower will pay \$272,610.22.

Interest = amount – principal

= \$172,610.22 + \$100000

= \$272,610.22

But in addition to the interest, three points and other closing costs of \$2000 are also charged on the new loan.

One point is equivalent to one percent.

The amount of money for the three points = 3/100*100000 = \$3000

Closing costs = \$2000

The total expenses for the new loan = interest + other closing costs + the amount charged on the points. With closing and points, we need to add \$5,000 to the mortgage

= \$100000 + \$2000 + \$3000

=105,000

The Benefit:

The new loan would only be profitable for the homeowner if they plan on residing in the home for an extended amount of time. If they are intending on moving in five years or less then the refinance does not make financial sense. Saving 2 % in interest can save some money, but if the plans are to only own for five years, the closing cost (Pre Pay penalties, origination fee, broker fees, title/ escrow fees, closing fees, etc.) with the three points make the savings a wash. Then there is the process itself, providing the bank all the documentation they need, (VOE, payoff demands, Appraisal, Credit report, and paying any debt that lender requires to lower your DTI to where they are comfortable, etc.)anything else the lender deems pertinent before they can close on the loan. There is also the total amount that would be saved. At the current rate for the next five years, the total mortgage amount to be paid is \$61,716.76. With the new mortgage, the amount total in the five years will be \$54,522.04. The amount saved would be \$7192.72. However, we need to calculate the \$5000 for points and closing, and the saving is only 2192.72. In an article by Journal of Financial Economics, it states, “households that fail to refinance when interest rate decline can lose out on tens of thousands of dollars in saving.” (Keys, Pope & Pope, 201,6) The saving for this refinance is only \$2192.72. This does not seem worth the time and energy for a home that is not your forever home

The other factor is why the homeowner wants to refinance? This is also a question that the lender will ask. Is he/ she looking to spend less a month on their mortgage, pay off high-interest rate debt like credit cards, cars, etc.? This is why a homeowner should speak with a loan officer about what they truly want out of the refinance. It has always been my suggestion that a borrower uses a Mortgage Broker in lieu of a bank. The mortgage broker can provide a tailored loan based on your situation from a plethora of lenders. Where a lender can only offer you the products, they make or all told to push this month. If the goal is just to pay down the loan faster then they can opt to make principal only payments in addition to their standard mortgage payment, “that extra payment can knock eight years off a 30-year mortgage, depending on the loan interest rate.” (Hogan, ND) Also, when they sell the property, they will get more money because they will owe less on the mortgage.

Conclusion:

My advice depends on whether the client wants to use the refinance to set themselves up for better financing on a new home or merely for lowering their payment. If the goal is to prepare themselves for a new purchase in five years, I would say refinance pay off take out just enough to pay off all their debt except your car and lover your interest rate. Over the next five years only use your credit cards in emergency and for no more than 10% of its available credit. Moreover, pay the full balance due at the end of each billing cycle. This will increase their credit score by at least 100 to 150 points, and that will save them thousands on financing charges and give them more financing options. If they want to just pay the mortgage off faster, then I would suggest not to refinance and pay more payments toward the mortgage. Make additional payment to the principle only so that when they go to sale, they have more equity in the home and thus a higher profit at the close that can be used toward the down payment of a new home.

References

# Keys, Benjamin J.; Pope, Devin G.; Pope, Jaren C.. In Journal of Financial Economics. December 2016 122(3):482-499 Language: English. DOI: 10.1016/j.jfineco.2016.01.031,

Virmani, S., & Murphy, A. (2010). An Empirical Analysis of Residential Mortgage Refinancing Decision-Making. Journal of Housing Research, 19(2), 129–138.