*whew* We’re finally on the other side of open enrollment, and can focus on the rest of our financial picture again.

I had a question come up recently, when someone with a relatively new mortgage on their first home asked if they should refinance. After all, the interest rates had dropped about a percent, and that’s the rule of thumb that people generally keep in mind.

There are three options you might want to consider, not just refinancing.

• Refinancing
• Putting the closing costs cash towards the principal of the existing mortgage
• Recasting

Option #1 is refinancing. Thoughts on refinancing:

Refinancing usually costs money.  You also want to make sure you don’t have a pre-payment penalty on your current or refinanced mortgage, as that affects early payoff due to refinancing (technically you’re paying off one mortgage and getting a new one) or paying off the house entirely. Did you know that national average loan turnover time is 7 years?

The usual rule of thumb is that it’s worth considering if the rate drop was 1% or more.  The person asking was very close to that, so considering is a reasonable question.

Are you at the beginning of your mortgage? A 30 year mortgage? Do you plan to take all 30 years to pay it off, or pay it off more aggressively?

Is your credit good enough you’re likely to get the advertised rates?  Those advertised rates are typically teaser rates for people with very good credit, many people get worse rates.

If you’ve got something other than a fixed conventional loan (like an adjustable rate mortgage), getting into a standard fixed rate conventional loan may to be to your advantage.  Recasting and paying down principal wouldn’t help make that switch.

Did you put down (or already reach) at least 20% for avoiding PMI and a second mortgage?  Second mortgages are usually at higher interest rates, and PMI is entirely money thrown out the window from the the homeowners perspective, so both of those would be a more advantageous use of money than closing costs if they’re applicable.  Or paying for a re-appraisal and potential other costs if you think the market price of the home went up enough that that may take care of the 20% issue.

You can roll closing costs into the mortgage, but then you pay interest on those for another 30 (or whatever) years as well.

Additional costs besides just closing costs that may come up, and also need to be considered.  If you plan to avoid escrowing, often there’s an additional fee for that, and that has to be re-paid with each new mortgage.  The house may need to be re-appraised, and that also has an additional cost.  Another round of title insurance.  And you have to take part of a day off from work (both spouses) to meet with the mortgage loan officer to apply, and then another part of a day off from work (again both spouses) to sign the new closing paperwork at a title office during bankers hours.  You have to read a new mortgage paperwork packet, which in my experience they don’t typically want to give you in advance, and it’s often full of “gotchas” that they’re trying to slip in – I hated it, and will be very glad to never do it again.  Going into another mortgage or refinance feels kind of like voluntarily climbing into a snake pit to me.

Remember that the new mortgage doesn’t have to be for another 30 years, with a lower interest rate and shorter mortgages typically offer even lower interest rates, you may find for example that you could refinance to a 15 or 20 year mortgage for the same monthly payment as what you have now, which saves a lot of money over the life of the loan.  Or refinance to a lower interest rate at 30 years, and pay it off more aggressively with the new cash flow when you can (discipline is required!) but gives you more flexibility for lower required payments if some months are bad.

You can run a mortgage calculator to see the total cost of your current remaining mortgage.  And then again to see how much the new mortgage would cost (remembering to add in all the refinancing costs either as cash out of pocket now or as part of the mortgage costs).

For reference, we refinanced (twice) due to a rate drop of ~1%, within a few years of starting the mortgage, and it was a bit over $4k in closing costs out of pocket if I remember correctly.  While it did give us more monthly cash flow that made me more comfortable (with new child care costs, decreased FTE for stay at home parent time and therefore decreased income, etc stressing our monthly budget) for a few years, in hindsight due to later shifting to an aggressive mortgage payoff stance, we would have been better throwing that directly at the principal.

Something the scientist in me always forgets – Loan officers are sales people, they’re going to try to sell you on refinancing with them.  Like when you go to a car dealer, they’re going to try to sell you one of the cars their brand carries, not the best car for you in the world, or talking you out of buying a car period  (and this is why I’d be a horrible sales person).

Option #2 is putting a chunk of cash on the existing mortgage:

If you were going to pay the closing costs out of pocket, you may be better off to just chunk that cash amount at the mortgage.  To assess that, you can run an amortization calculator to get an amortization schedule, and look at the amount of interest difference a lump sum extra payment of $___ at ___ months into your mortgage would make in lifetime cost of the mortgage.  It’s more useful at the beginning of the mortgage, because that’s when more of the normal monthly payment is going to interest than to principal, so throwing a large dollar amount at the principal is most effective. Then again, if you’d had more money sitting around when you were purchasing the house, you would likely have already used it on your downpayment. There is a bit of catch-22 here.

Option #3 – Recasting

A third option to consider, if you’ve got a lump sum of cash sitting around that you were going to use for refinancing costs – recasting the mortgage. That’s out of scope for today’s discussion, but it’s something you can consider.

You can run the numbers yourself if you are comfortable with it, or you can get help with that. You need to know what your original mortgage amount was for, when it was begun and its duration, your current and proposed interest rates, the proposed loan duration, and how much cash you have available to throw at the situation.

Of course, if you want to over-complicate things, you could always throw in Option #4 – sell the house and rent an apartment 😉