Mortgage Refinancing Advice from
a Founding Father

"A penny saved is a penny earned," advised Benjamin Franklin. Or to put it not quite so memorably: "Cutting expenses produces the same budgetary result as earning more money." Actually, because income today is taxable (something old Ben didn't have to worry about), cutting expenses can actually produce a better bottom-line result than earning more.

For many of us, one of the largest expenses of life is the cost of interest paid on a home mortgage. The good news is that, if economic conditions are right, implementing the "Franklin principle" with a mortgage is fairly easy—and it can pay off big. Putting in just a few hours of research can result in a huge reduction in your interest expense. Over time, the effect will be roughly the equivalent of a significant increase in income.

So how do you save all those "pennies"? It involves refinancing your mortgage at the right time to get a lower rate and/or a shorter term. You simply pay off your existing loan with the proceeds from a new, lower-cost loan. Refinancing can reduce your overall interest expense by tens of thousands of dollars, putting you in a much better long-term financial position.

With most refinancing situations, a key piece of information in deciding whether to refinance is how long it will take to "break even." In other words, at what point will you recoup the upfront costs of refinancing? These upfront costs include legal fees, the cost of an appraisal, the price of a title search, and, of course, some profit for the mortgage company. Usually, the lender will charge a "one-point origination fee." A point is equal to 1% of the loan amount. (You might also choose to pay additional points in return for a lower interest rate on your loan.)

Once you shop for the best deal by comparing closing costs at various lenders, use a mortgage calculator to calculate what your new monthly principal and interest (P&I) payment will be. If your payment is going down (it might go up if you're moving from a 30-year loan to a 15-year loan, but this is actually a good thing as we'll explain shortly), subtract the amount of your new P&I payment from your old one. This tells you how much you'll save each month. Divide this monthly savings into your closing costs. This tells you how many months it will take before the refinancing pays for itself (tax considerations aside). That's your break-even point; after that, you're saving every month.

Example: If your new monthly payment would be $140 less than your current one, and if your total closing costs (including one point) were $2,800, it will take 20 months before your savings equal your expenses ($2,800 divided by $140). After that, you'd be ahead an extra $140 each month.

It can get confusing trying to compare different proposals (lenders have lots of different ways of packaging loans), so here's a handy way to convert points into a percentage rate: treat each point as if it added ¼ of 1% to your loan rate. Example: a 6% rate with one point is roughly the same as a 6¼% rate with no points.

Once you know the break-even point for each loan you've been quoted, the main consideration is how long you expect to be in your present house. If you won't be there long enough to reach the break-even point, don't refinance.

If you think you'll be in your house past the break-even point, you still have to decide whether to take a loan that features a lower rate but more points upfront, or a higher rate with fewer points. The general rule is that if you don't plan to be there much past the break-even point, lean toward the lower transaction costs. That means a shorter stay equals fewer points with a higher rate; a longer stay equals more points but a lower rate.

To simplify things, some lenders now specialize in a "no points or closing costs" option. They let you skip the points and closing costs entirely in exchange for a slightly higher interest rate (this is sometimes called a "par quote" mortgage). Then it becomes simply a matter of comparing the rate they quote you with the rate you're paying now. For example, if you're paying 6.50% and can get a "no points or closing costs" rate of 6.00%, you're guaranteed to save. There's no reason you wouldn't want to refinance many times over the years when the advantages are this clear cut.

Sure, there's some paperwork involved, but there's probably nothing else you can do that will pay you (in saved interest) such a high hourly rate for your time! In fact, it's worth checking every few months and consider refinancing anytime you can save at least one-quarter of a percent on a "no points or closing costs" basis. Why? Depending on the overall level of rates, you'll save $6,000–$7,000 in interest over 30 years on a $100,000 mortgage for every one-quarter percent reduction in your rate.

Keep in mind, however, that the shorter the remaining term of your mortgage, the less you will save. If you have less than ten years remaining on a 30- year mortgage, it is unlikely that refinancing will result in much savings.

If you still have many years left on a 30-year loan and really want to save big, the best way is to replace it with a 15-year mortgage. The monthly payment will be higher, but the interest rate will be lower—and the long-term savings in interest will be dramatic. (One of the SMI staffers refinanced from a 30-year loan to a 15-year note earlier this year, and will enjoy an estimated interest savings of $90,000 over the life of the loan! Ben Franklin would be proud.)

Other things to keep in mind about refinancing:

• You can refinance with the original lender or go to a new one. It usually pays to compare offers from other lenders.

• Be sure to find out when the rate on your loan will be "locked in" (permanently set). Is it when you apply? When the loan is closed? Many borrowers have been hurt when interest rates rose after the original proposal was made but before the lender locked in the rate.

• Get a commitment in writing of the exact terms of the mortgage being offered and how long the offer is good for. It should include the circumstances under which the lender would be allowed to back out; for example, in case of a dispute over the appraised value of your home. Make sure the loan allows you to make additional principal payments (a "prepayment option") without any penalties.

• Check with your loan officer or processor to find out when the appraisal and credit agency reports are due back. Call on the expected dates to make sure they come back in good shape.

Joseph Slife is a contributing author and editor for SMI. He spent 15 years with Crown Financial Ministries, co-writing articles with Larry Burkett and serving as executive producer for broadcasting. In addition to his work with SMI, Joseph is an adjunct instructor in the Dept. of Communication at Emmanuel College in Georgia.

• SMI's Mortgages page
• Big Savings Through Small Mortgage Pre-Payments 
• Bi-Weekly Mortgage Plans: Peeking Behind the Curtain 
• Editors' Weblog: Opportunity Knocks 

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