Crazy times, crazy decisions: Getting caught up in the refinance mania

07.15.09
By Randy Johnson

During uncertain times like we are experiencing today,  it becomes very difficult for many people to figure out what to do next. Confusion reigns. I see this manifested in several ways.

We get calls from people who get caught up in the publicity surrounding refinance mania. They want to know if refinancing makes sense for them. There is nothing wrong with that. In fact, I think that an annual check-up on your mortgage should happen when you look at other aspects of your financial life, like your 401(k). Most people cannot remember their interest rate or the terms of their loan. Sadly, my experience is that about half of the people I encounter can’t even remember the name of their lender.

But some of those people don’t want to proceed even though they can save significant amounts of money if they were to refinance. They can see the costs, but the benefits are not clear. In many cases they carry around baggage from long ago, baggage that is not relevant today.  Let me give you an example.

The old rule of thumb was that you shouldn’t refinance unless the rate dropped by 2 percent.  This maxim is from the 1980s when the average property value in this country was a little over $100,000 and the average loan was $68,000.  On a loan that size, it would take a 2 percent drop to generate enough dollar savings to justify the closing costs. Today, of course, the average loan amounts are much higher – and as a result, all it takes is a 1 percent drop to justify refinancing.  

Before we work through an example, I want to mention some interesting research that psychologists have done. They test peoples’ propensity for immediate gratification versus long-term gratification. Given a choice between $50 today or $100 a year from now, most people opt to take the money now.  They didn’t make this offer to you so you can look at it dispassionately. You can see that if you took $50 today and banked it, you might have $51 or $52 a year from now. Obviously $100 is a much better choice.

The genesis of this is probably is buried in our limbic system from our days as hunter-gatherers when a small meal today might have been far more important than a meal twice as big a year from now when you might not even be around to eat it.

However, part of being sophisticated, civilized people is that we can let our minds override our primitive urges. We have an opportunity to apply rational thought to our choices.  Mankind progressed when he took up agriculture and could assure a stable food supply instead of relying upon what he could find. Having the time to analyze the long-term benefits of our actions became a critical feature of our success back then. It’s true even today. Example:

On a $300,000 loan, a 1 percent drop saves $3,000 per year. Therefore, if closing costs were $6,000, you would recoup them in just 2 years. That’s terrific.

I know that may not look good to some people, but they are crazy. First, they focus on that $6,000 cost. Writing a check for $6,000 when you are unclear of a future advantage may produce some anxiety. But look at it this way:  If you leave the $6,000 in the bank, it will earn about $100 interest each year. If you refinance, it will save $3,000 each year.  

Let’s look at it in more detail. Let’s say you had a $300,000 loan at 6 percent and you had an opportunity to refinance at 5 percent and costs were $6,000. With your current loan, the total interest over the life of the loan would be $347,514. If you refinance at 5 percent, the total amount of interest you owe would be only $279,767. That’s a saving of $67,747 on an investment of $6,000.

It gets better. If you refinance and keep the monthly payment the same, you shorten the payback period to 24 years instead of 30 years. The cumulative interest drops to $213,608. That’s a saving of $133,000, and all it costs is $6,000.

And you may not believe me, but some people will walk away from that because the way they look at it, it doesn’t pay. Crazy, huh?

I know of a borrower whose property didn’t appraise for enough to do an 80 percent loan-to-value loan refinance. She either had to pay PMI or pay down the loan to an 80 percent level. The numbers didn’t vary much from what I just showed you, and she had enough money in the bank. But she didn’t want to write the check. She would have saved tens of thousands of dollars, as in our example above. Crazy.

Today there are many people who are under water, meaning they owe more than their home is worth. Recent estimates indicate that as many as one in five homeowners is in that situation. For many, things seem hopeless. No longer.

The good news is that under a change in policy just last week, there is help for some of these homeowners. A homeowner may be as much as 25 percent underwater, and if his loan is owned by Fannie Mae or Freddie Mac, he is still eligible for a refinance. If you owe $250,000, for example, even if your home appraises for only $200, 000, you are eligible. For more information, visit MakingHomeAffordable.gov.

Finally, I got a call recently from someone with a 5.25 percent fixed-rate loan. Not only is she in great shape, there isn’t anything that would improve her position enough to justify a refinance. But I’m glad she called. That wasn’t crazy.

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Today, all it takes is a 1 percent drop to justify refinancing.