FrugalJim

An avid reader of FrugalJim.com, Al, wrote in to ask me a question:

Hi FrugalJim!  I was just wondering your thoughts on a question I’ve been contemplating…  I am currently trying to decide if I should refinance my mortgage.  Currently, I have about $185,000 left on my mortgage at a rate of about 6.5% or 6.75% APR, making my monthly payments around $1,200 with 28 years and 10 months to go.  I recently received a letter from my mortgage holder telling me they would knock 1 point off the fees if I refinance at a rate of 5.125% or 5.4% APR (assuming 1 point).  What do you think?

-Al

Well, the first thing I would do is calculate how much you have left to pay off your current mortgage.  Just multiply the 28 years and 10 months by $1,200, getting $415,200 as the total amount you would end up spending if you kept your current mortgage.

The next thing I would do is determine the monthly payment of the refinanced mortgage.  Just plug the 5.4% APR and $185,000 amount into a mortgage calculator online, and you get around $1,000 for the monthly payment.  This would end up saving you a monthly amount of $200 off your current payment.  If you multiply the $1,000 by the 30 years you would be paying it back, you would get $360,000, saving you a total of about $55,000 over the life of the new loan if you refinanced.

Now right away you think… “This is a No Brainer!”.  But you have to wonder why the mortgage company would want you to do this, if it will save you money (ie: make them lose money) in the long run.  Well the real answer is Fees.  The banks are so hard up for cash right now, that they need every dollar they can get right now, and are only worried about making it through the next couple of years, and not the long run.

So lets figure out about how much the fees would be.  Well, a refinance with 1 point would have a base fee of 1% of the refinance amount.  So 1% of $185,000 is $1,850.  And of course there will be other miscellaneous fees (application fees, title fees, appraisal fees, lawyer fees, etc), and we’ll just ball park it at $2,000.  This brings the total cost at around $3,850.

Does this still make sense?  Well, upfront costs would be approaching $4,000, but over the long run, you would save about $55,000.  So if you kept the home for 30 more years it would definitely be worth it.  Otherwise, we would probably want to know the break even point…  Take the $4,000 and divide it by the monthly savings of $200 and you get 20.  To break even on the refinance you would have to keep paying the mortgage for 20 months.

Well, Al…  If you plan on staying in your house for more than 2 years, can get a loan payment of $1000, and don’t spend more than $4,000 in refinancing fees, I think it would be a good long term move to make.

The stock market gurus out there like to talk about the idea of “rational market”.  It basically says that the market overall is rationally priced based on the information that is available to the public.  The one problem I have with it though, is that it assumes the people behind the market are rational.

As I walked back from the gym with rubbery legs today, I realized that I am totally not rational.  If I was, I wouldn’t have stuffed my face over the holidays and instead would be in exceptional health.  Trying to make sure I am absolutely healthy so that I live the longest most productive life I can makes the most sense over any other factor, yet when someone puts a piece of pecan pie in front of me…

In essence, there is a battle of short term rationality at conflict with a long term rationality that should obviously win, but somehow I make the wrong decision.

Is there a similarity with what’s going on in the economy?  If I keep hearing that the economy is going to hell, yet there are what seem to be good deals on stock prices out there, does the short term security of not buying stocks override the longer term benefit of making a big return?  If I could refinance my mortgage to save tens of thousands of dollars over the life of the loan, yet I’m too scared to spend the money to do so, does that make sense (directed at the wife )?

Anyways, I think that sometimes we get bogged down with what’s going on right in front of our face, instead of taking a step back and looking at the bigger picture.  I’m going to try and remember that.