I know a lot of people who think that your US mortgage “restarts” if you refinance. That is not true. If you are able to refinance your mortgage with a new rate just .25% a little bit lower than your current rate, the cost of refinancing can pay off within just a year!
A little bit of “Mortgage theory”
Each and every mortgage payment you make is the sum of three components:
- The interest on your total balance (balance=the amount you owe), which is exactly the interest rate you have (APR) divided by 12 (because the “A” in APR means annual, and you make 12 payments, once per month in a year). This is the what I will call the basic rule of mortgages.
- A principle payment that is exactly what is necessary to cause your mortgage, with your given the APR, to be totally paid off after the duration of your mortgage.
- If you have an “escrow account”, then there is an addition of property taxes and property insurance which is independent of the above two.
For a normal fixed-rate mortgage, the sum of 1. and 2. above will never change. Gradually, 1. will decrease and 2. will increase.
What happens when you do a refinance
Every time you make a payment, the part of your payment that goes to “principle” changes what you owe, by making it decrease a little bit. As a consequence, your costs go down if you can lower your APR. You can lower your APR by refinancing, and refinancing doesn’t change your principle; what you’ve already paid off is what you’ve paid off.
When you refinance, you, do effectively “restart your mortgage”, which is probably why the myth I’m discussing here is so stubborn! You had a 30 year mortgage, you were paying it off for 10 years, and then you refinance and you have a 30 year mortgage again. That sounds like a bad deal, but here’s what you’re missing:
- You can just get a 20 or 15 year mortgage instead of a 30 year mortgage. You could get a 15 year mortgage and maybe have a higher monthly payment, but pay off your mortgage 5 years early and save hundreds of thousands of dollars. Generally, shorter mortgages have a lower interest rate, saving you even more!
- You can get a new 30 year mortgage at a lower rate, and overpay it, making your monthly cost effectively the same, but you still pay off your mortgage years early! I’m not even sure it’s possible to get a mortgage that penalizes paying off a mortgage early.
Sometimes, people say “you pay the interest first”. This is simply not true! This is the main crux of this myth. No, you do not pay interest first! You only pay the interest on the existing balance. It just seems that way, because, per my basic rule of mortgages, when you owe more, you are paying more for interest, and as you pay off your mortgage, you owe less!
The catch: refinance fees
It costs money to do a refinance. The bank will charge you “origination fees”, they might charge you appraisal fees, in certain consumer-hostile states there might even be a refinance tax, because the banks successfully bribed your state to make those taxes so that you don’t refinance.
These fees can be thousands or 10s of thousands of dollars. But they are the only reason that it might take a year or two to “break even” after refinancing. Just subtract those fees from your savings to see the break-even duration. If that duration is less than a couple years, it’s probably a good idea to refinance, unless you expect rates to get even lower in that time (they probably won’t right now, IMO).
A note on variable rate mortgages
Variable rate mortgages are not necessarily a bad deal and may very well be a good deal. They don’t really change the formula above very much other than that the APR can (and will) change. In the interests of simplicity, I disregarded the effects of a variable rate mortgage, other than to say that most of the content of my post probably still applies.
Final notes
Shop Around! Shop around when looking for banks! Even after you have a “preapproval” letter from your bank when you are first house shopping, you can still shop around even though they say you cannot (a contract isn’t a contract until money changes hands!).
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From a UK perspective, it always struck me as odd that remortgaging just doesn’t seem to be a common thing in the US.
In the UK, it’s normal to have a fixed rate guaranteed for only a few years and then when that rate expires (usually going up quite a bit), everyone does the remortgage dance similar to how you might shop around for a new utility provider or phone plan.
Here in Canada, amortization periods and mortgage terms are totally different things. Nobody takes a 30 year term. Most common is a 5 year term on a 20, 25 or 30 year amortization schedule.
Some people take 10 year terms when rates are awesome and they want the comfort of knowing what the payment will be for a decade.
Relative rates between terms is driven by what the current and projected rates are. For instance, if current rates are high and the projection is that they will drop in the future, then a 5 year rate might be lower than a 1 year rate. If current rates are low, then the 5 year rate would usually be higher, but how much depends on the projections.
For pretty much the entire period from 2008 to 2020, the rates here in Canada were incredibly low and projections were to stay low. So the spread between a 6 month term and a 5 year term was minimal. People got used to that.
In Canada, every time you renew your mortgage at the end of a term, it’s an opportunity to shop around for better rates, pay some more down or fiddle with the amortization period. There might be fees or the need for a new appraisal if you change lenders but none of that if you just renew with the name lender.
We used to take shorter terms, often 6 months and usually no longer than 2 years, and always shaved off at least 6 months extra off the amortization remaining at each renewal. The only time we went longer was in 2007 when I was convinced that inflation was on the rise and would drag the rates up. So we picked a 3 year term and 6 months later the crash came and rates dropped 3% over the next year or so.
I want to appreciate that you specified its for the US and not just assumed everyone reading would be in the US.
Yes, a rare thing to witness in the wild.
Thanks! It’d be interesting to know how the laws around this stuff differ around this world.
It’s illegal to be outside the US but don’t worry I’ll send ICE to get you all nice and deported. /s
(the /s is silly not sarcastic in this case, btw)
What you’re saying is mostly correct but the conclusion that a 0.25% rate reduction could pay off in less than a year is overly optimistic for most any borrower in the US mortgage market.
Using their example:
As interest rates fall, millions of borrowers may be able to refinance and get more affordable payments. As interest rates eased down to 6.5%, about 2.5 million borrowers could already refinance and save at least 75 basis points (0.75%) on their interest rate, according to data from ICE Mortgage Technology. A reduction in rate from 7.25% to 6.5% would result in a $200 monthly savings on a $400,000 loan with a similar term. If interest rates fall to 5.5%, more than 7 million borrowers can potentially refinance, and over 5 million of these refi candidates got their mortgages in the past three years.
So a .75% reduction saves $200 a month on their example mortgage, meaning that to make a refinance break even in less than a year would require origination and other fees to be less that 12*$200 = $2,400, and that’s with 3x greater reduction in rate than your statement.
Given that the 2023 median refinance fees were around $7,000, often ranging from 3%-6% of the principal, you would need a more substantial rate reduction to break even on 0.25 in one year, and in that range would likely have a 8-10 year break even.
Which is fine if you strongly expect to stay in the house for at least that long.
Note: while pre-approval letters didn’t generally obligate you to use that lender, the general statement that a contract isn’t a contract until money changes hands isn’t correct as consideration under a contract can take many forms, so talk to a lawyer about your specific situation.
The rest of the advice is good. Shop around for mortgages, look at mortgage brokers and credit unions, keep your old payment to accelerate payment (though it might be better to invest the difference depending on rates), and to run the numbers for your actual mortgage as the refinance market changes is all sound.
but the conclusion that a 0.25% rate reduction could pay off in less than a year is overly optimistic for most any borrower in the US mortgage market
As is the “saving hundreds of thousands of dollars” part unless your mortgage is millions of dollars.
- You’re right, I was taking numbers from years ago where .25% was a more significant fraction of an APR than now. But if you have a 7% mortgage right now, you can probably get one for 6% right now.
- Indeed, “money exchanging hands” isn’t the only way to get consideration
There’s a lot of stuff I didn’t discuss, like “points” which are not explained well by lenders (and sometimes I think they keep it purposefully obtuse).
thanks for making me think about this. unfortunately i don’t think interest rates will be going down again in my/the usa’s remaining lifetime.
I agree, I don’t think interest rates will be going down in the next 5 years. 🧐
heh. is that how long you’re giving me or the usa?
Yeah this was all great information for the years leading up to about 2022. I refinanced several times in the decade leading up to that. But now, interest rates are steadily rising. Gonna be hard for anyone to take advantage of refinancing for a lower rate.
In the global financial crisis, in at least California, which is a non-recourse mortgage state — that is, if someone defaults on a mortgage, the lender can only go after the property — a number of people discovered that if they refinanced, the new mortgage was recourse, and a lender could go after other assets and wages to cover the default. For people who bought into the top of a bubble, then walked away from the house after prices dropped and they were underwater, had negative equity, this was a major issue.
Those rules were later changed, but I would be careful to understand the implications of refinancing a mortgage in your particular jurisdiction, as they may be non-obvious and substantial.
You should also know that paying off your mortgage completely may negatively impact your credit score at least for a while. This is because they tend to be held so long that when it closes your average age of credit accounts decreases. This isn’t typically a good reason to not pay off your mortgage but depending on your situation you may be better off looking for a second mortgage before the final payment as opposed to directly after it.
But what good is a credit score except for a mortgage? If it wasn’t for that one thing, there is no need to care, unless you are borrowing for a small business loan or purchasing more property.
When I renewed my mortgage, from 4.25 to 2.85, I was given the option of resetting to thirty years to reduce the monthly payment.
I took the offer, on the theory I’d be better off investing the difference than paying the principle. So far, it’s paid off.
There are two things missing from that calculation. First, the mortgage savings are generally after tax, while investment gains are taxable. So the comparison of break even needs to take this into account.
Secondly, if pay off the mortgage earlier, then you have some number of years at the end where you can then invest the entirety of your payment instead of paying mortgage.
The calculation should be to compare the net effect of the taxable investment of the lower mortgage payment difference for 30 years vs the net effect of paying less total interest over 20 years, plus investing the entire mortgage payment for 10 years after the mortgage is paid off.
Otherwise, you’re not comparing apples to apples.
The last thing isn’t numbers, really. You can live in a house, you cannot live in an investment account, and you have to live somewhere. If the market crashes it takes your investments with it, but if the housing market crashes, then you can still live in your house. And if for some reason you have to sell the house, then owing less on it - guaranteed - is a good thing, no matter if the value has gone up or tanked. That does something to the risk calculation.
Not to mention the discipline bit that you mentioned. Life has a habit of getting in the way, and the decision to invest is always an open question whenever something happens. The decision to pay a higher mortgage for a shorter term is closer to firm than that.
There are two things missing from that calculation. First, the mortgage savings are generally after tax, while investment gains are taxable. So the comparison of break even needs to take this into account.
Long term taxation on investments is 15%. So, at a 2.85 interest rate we’re still talking about 3.3% ROI. I can beat that buying a US Treasury Bond.
Secondly, if pay off the mortgage earlier, then you have some number of years at the end where you can then invest the entirety of your payment instead of paying mortgage.
But you’ve foregone all the income returns in the initial years that you failed to invest in the market.
Let’s be conservative and predict a 7% market ROI (right now, the markets are doing closer to 25% YOY). If my options are $1100 mortgage payment over 25 years or $1000 over 30 years, I’m looking a 25 years of $100/mo savings ($1200/year -> 25 years = $30,000). By the time you’ve paid off your mortgage, my accrued investment returns amount to around $78k. So we’re going into year 26. I’ve got $78k in investment principle, at 7%/year, earning me $5400/year. That’s nearly half my mortgage note. You’re putting your first $1100/mo => $13,200/year into savings, having missed 25 years of compounded returns.
Up the ROI from 7% to 10% (the historical DOW return over the last 30 years), and now I’ve got $123k in principle, earning $12,300/year, which is more than the mortgage note.
The excess you’re paying into the mortgage is effectively an investment with a yield equal to your interest rate. If you were paying an 11% note, getting rid of your mortgage quickly makes sense. But at 3%, it does not.
The raw math becomes ($mortgage payment)(ROI - Interest Rate) = Implicit Return.
The last thing isn’t numbers, really. You can live in a house, you cannot live in an investment account
In both scenarios, we’re living in the house. The amount you pay on the note doesn’t change that.
Not to mention the discipline bit that you mentioned.
That’s where the math ultimately gets fuzzy. Are you actually banking the $100/mo in mortgage savings as investment? Or are you just shoving it in your savings account and forgetting about it? Or spending it?
I find that periodic automatic transfers do a lot of this book-keeping for me. 401ks come out of my paycheck before it hits my savings account. I’ve got an automatic monthly deduction for my son’s 529 and my Roth IRA. And I try to do a sweep from my savings to investments roughly once a month, when I’m over a certain cash balance.
But I’ll concede all this requires a certain surplus income. If you’re stuck living paycheck to paycheck, its possible that paying down the mortgage faster is just less of a headache than juggling balances to make sure ends meet.
I’m in Canada, not the US, so some of the practices are strange to me. But Google tells me that a typical rate for size of mortgage in your example is 6.6%, not 2.85%.
Just for shits and giggles, I ran this past Google Gemini to crunch the numbers. A 250,000 mortgage at going rates for 25 and 30 years with the difference invested for 30 years vs investing the entire payment amount for 5 years after paying off a 25 year mortgage. And accounting for taxes.
Basically, they tie at a 9% RoR, and the longer mortgage wins by 25K at 10%. But let’s also remember that is future dollars, with a PV of about $11K.
Also of note, the 25 year mortgage has a slightly lower rate than the 30. That impacts the result a bit.
But Google tells me that a typical rate for size of mortgage in your example is 6.6%, not 2.85%.
Today, certainly. Back in 2020 when we were entering the COVID-induced recession, the prime rate plunged back into ZIRP territory and you could refinance a mortgage incredibly cheaply.
Also of note, the 25 year mortgage has a slightly lower rate than the 30
Generally speaking, your options are 15 year or 30 year (at least in the US). The difference in interest rates is typically marginal, though. Maybe .5 pt, from what I’ve seen. The real perceived benefit is paying off the debt faster. But… again, if the loan is large and the interest rate is small, you’re putting a lot of cash behind a comparatively low return.
What are yoy talking about, life is a spreadsheet. Sort by Column J and do the one at the top.
Really!
I’m shocked that investing the difference actually worked out better for you. Everyone is always talking about paying off your debt first.
It’s literally as simple as deciding if you can earn more than the interest rate of your mortgage. Even a savings account at 3% interest beats a mortgage at 2.75%, dollar for dollar.
The hard part is having the discipline to not spend the money.
Getting above a 2.85% return is pretty trivial.
Paying off your high interest debt is a priority, because it’s very hard to find anything that’ll get you Credit Card Interest levels of return. We scrambled to pay down our student debt, which was in the 7-8% range. Maybe not the best move, but it was a conservative decision. If you’re into the double digits, definitely get rid of that ASAP.
This is useless for me as I will never own a home in my life
Surely you’ve not cut out the avocado toast yet
Is the financial institution you are currently borrowing from required by law to comply with refinancing? If not, it is hard for me to see how they would allow this, since you usually refinance for a better deal.
When you refinance you’re ‘paying off’ your old loan and starting a new one, so there’s nothing they can do to stop you.
If I understand correctly, you are asking if your lender will let you refinance. The answer is that it’s not up to them, you go to any other lender and try to get a better deal, and then they pay off your old loan and get you a new one. Your old lender (to my knowledge) cannot refuse the payoff.
There’s also something called a Mortgage Recast, in which you make a one-time payment and your existing lender adjusts your payment schedule at the same interest rate.
