What brokers and loan originators may not tell you
Let’s take a simple study example. Assume the original loan and refi with the following parameters:
- the original loan: $100K for 30 years @ 4%.
- the refi loan: $100K for 30 years @ 3%, closing cost: $13,237.83.
Yep, I know, it’s a magic number and closing cost: 13% is too high, but please, follow me.
Is it worth to refi?
First, let’s assume that we add the closing cost into the loan. Basically, we are going to compare two 30 years loans:
- the original loan is $100K @ 4% versus…
- the refi: $113,237.83 @ 3%.
Actually, in both cases, monthly and annual payments will be exactly the same. This is because of the magic number!
- the annual payment: $5,728.98,
- the monthly payment: $477.42 ( = $5,728.98 / 12).
Each monthly/annual payment consists of two parts: principal and interest.
At the beginning, the interest is usually bigger than the principle, but towards the end of the loan, the principal increases, while interest goes towards $0.
The loan annual rate has higher impact on the interest, while the balance (loan+closing cost) impacts more on the principle.
So if we take a look at the first annual payment of each of two loans, we can notice that the interest in the original loan is higher than in the refi. Intuitively, it is clear since refi has bigger balance and lower annual rate.
The original loan first year annual payment:
- the interest: $3,967.95
- the principal: $1,761.04
- the payment: $5,728.98
The refi first year annual payment:
- the interest: $3,364.80 (lower)
- the principal: $2,364.18 (higher)
- the payment: $5,728.98 (the same)
We may also compare the total amount paid in the case of each loan (including interest and the principal).
The original loan:
- Total interest paid: $71,869.51
- Total principal paid: $100,000.00
- Total payments: $171,869.51
- Total interest paid: $58,631.66
- Total principal paid: $113,237.83
- Total payments: $171,869.49
As we expected with refi, we pay less in interest but more in principal.
Clearly, if we are offered better deal, e.g., with lower closing cost or with lower annual rate, we should see lower monthly/annual/total payments. And probably we may start saving money…
Unless we tax-deduct the interest payments!
If you bought a home after Dec 15th 2017, the interest from the first $750,000 of the mortgage could be tax-deducted (other constrains apply: the home must be primary or secondary residence, etc).
Homes bought before that date has the higher limit: $1M (for the mortgage). Yeah, fo someone who is asking why? This “improvement was introduced by “2017 Tax Cuts and Jobs Act”.
In order to tax-deduct the mortgage interest, the tax-payer must request itemized deductions.
For those who prefers to take standard deductions, the following discussion does not really apply!
Paying bigger portion in interest more aggressively reduces the after-tax payments.
In the considered case above, if we assume 22% tax bracket, then the original loan has lower after-tax payments.
The annual after-tax first year payment:
- for original loan: $4,856.04
- for refi: $4,988.73 (higher!)
The total after-tax payments:
- for original loan: $156,058.21
- for refi: $158,970.53 (higher!)
In this case, refi actually costs by $2,912.32 more in after-tax money. Probably, strong argument against refi?!
Let’s assume the following better-deal refi: it has half of the closing cost, namely: $6,618.92 (6.6% of the loan).
In this case, each year refi will save from $159 to $327, in after-tax money!
Are we happy?
Remember that for the initial period, the loan balance in refi could be higher than in the original loan. This is because we added the closing cost to refi’s loan. Bigger loan, bigger balance!
Practically, if we decide to sell the home (or even refinance) we will have to close the balance, which for the case of refi, could cost us more.
If the saved money on refi payments does not cover the difference in balances, one may argue that the refi does not make sense.
For this particular case, the “break-even point” occurs only after 11 years of payments. Which is pretty long.
By the 11th year, refi payments will totally save: $2,014 (after-tax).
And at the same time, the loan balance for refi is bigger than for the original loan by $1,526.
Yep, if we sell the home in the 11th year and will cover the balance, we will make only $2,014 — $1,526 = $488 (after-tax).
We should be careful if there are plans to sell the home in short-run.
If we keep paying for entire 30 years, the refi will save $6,379 (after-tax).
There is another topics connected to the discussion: “the opportunity cost”, but… let’s talk about this next time.