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My home mortgage was originally $602,400 when I initiated it in 4/2015, with a fixed 30y rate of 3.75%. No mortgage insurance. The principal balance is now $539,315. I'm being offered a rate of 2.875% IF I bring an extra 29k so that my jumbo mortgage becomes conforming. So I would be starting this new mortgage with a balance of $510,400. I'm told that closing costs would be in the vicinity of $5,500 everything said and done. I'm planning on staying in the house in the near future, at least 2 years and more if possible career-wise.

According to my calculations, this lowers my monthly payment by about $650, so this works out to a yearly $7,800, which I see as a guaranteed yearly return of 27% on that $29k (not taking the closing costs into account). This is more than I would hope to gain from investing this in the S&P 500, which is where I normally invest.

Is my logic flawed at all? I'm sure there are many other variables but did I miss anything huge that would significantly change my conclusion?

Thank you!

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  • The big flaw in your calculations is it looks like you are calculating your reduced monthly payment by assuming you extend the mortgage out to a full 30 years (unless my math is wrong). This is the wrong way to look at things because reducing your principal payments isn't the same as 'a return of 27%'; only the interest reduction represents financial return.
    – Grade 'Eh' Bacon
    Commented Aug 7, 2020 at 13:14
  • From my answer - "Another chunk [of the saving] from going back to a new 30 year amortization."
    – JTP - Apologise to Monica ♦
    Commented Aug 7, 2020 at 14:22
  • I definitely feel like there is a flaw. Obviously not a money person! But my way of thinking is as follows: I have 29k currently invested in the S&P (average annual return 9.8%). If I took that money and applied it to the mortgage in the form of this refinance, I would be saving $7,800 a year (more than the $2,900 the money would be generating on the market). Say I sell the house in 5 years (random number), I will have saved $39k and I get my $29k back. On the other hand, say I sell my S&P stock in 5 years, I have made $17,282 and I also get my $29k back (assuming 9.8% returns every year).
    – sw1337
    Commented Aug 7, 2020 at 15:05
  • I think what you're saying is that by refinancing, now I'm back to making almost 100% interest payments, therefore not reducing my principal balance. So whatever money I save on my monthly payments is negated by what I'm spending in interest payments?
    – sw1337
    Commented Aug 7, 2020 at 15:19
  • I am saying in my answer below that for an apple to apple comparison, you need to dig deeper than how you viewed it. Learn to get comfortable with a spreadsheet and run the numbers. Suggesting that the choice is paying down the mortgage a bit or getting a 9.8% return is not quite correct either. But, a bit of work and you calculate the return precisely with a couple spreadsheet columns.
    – JTP - Apologise to Monica ♦
    Commented Aug 7, 2020 at 17:31

1 Answer 1

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Here's my math. You need to start by taking the current balance and using 24 yrs 8 months as the term. At the new rate, you'd pay $244/month less. If closing costs are $5500, the break even is 22.5 months. After that, consider the return on your $29,000. Just about 10% for having paid it to the mortgage. A chunk of that 'huge savings is from you lowering your own balance. Another chunk from going back to a new 30 year amortization. The deal is good, especially if you stay long term. Just not quite as dramatic as your numbers.

Years ago, I did something similar. I had a $480K mortgage 7.625%, and was able to drop it to $380K at 5.25%. But. At the same time I dropped from the remaining 25 years down to 15. Paying down the principal so much also dropped 10 years off the back end. That was at a time when the going rate was actually lower still, and the 5.25% came with zero closing costs. To sleep better at night after depleting nearly $90K from the emergency acct, I set up a HELOC at the same time. Having a credit line sub-5% seemed wiser than having $90K earning near zero interest. Many warned this was an awful idea. And I suppose a number of things could have gone wrong. I only offer this anecdote to share my own experience.

In the end, I'd then keep the 2.875% as long as possible, i.e. don't actually pay on the 22 year math, keep it to 30. Use the savings to kill any 5%+ debt you might have, and invest the rest for retirement. The actual $8K/yr cash flow will help you replenish savings if needed.

UPDATED ANSWER -

We need to eliminate the effect of refinancing for a longer term. I have looked again at the numbers and 24.75 remaining time seems right.

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You save $385.90/mo for a cash outlay of $34415.

Since this is for 24.75 years, it's treated like an annuity, i.e. the flow of money isn't forever, it's a fixed term.

To get that cash flow from $34415 would require a return of 12.89%.

Of course, that assumes you keep the mortgage for the full term. Which is why people also say $5500/$386 = 14.25 months to break even on the closing costs. In the end, I suppose one can calculate the return for shorter end times as well. Obviously, selling the house at about 14 years or sooner gives a zero return as you only gained enough to cover closing costs.

Again, I'd not suggest you actually make those payments. At sub-3%, I'd use the extra (cash flow) of $672 more wisely.

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  • I understand emergency funds are typically six months' expenditure... How come yours was $90k!?
    – Adam Barnes
    Commented Aug 7, 2020 at 8:08
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    Nothing magic about the 6 month rule. We were running higher.
    – JTP - Apologise to Monica ♦
    Commented Aug 7, 2020 at 11:24
  • 1
    @AdamBarnes Consider how long it can take to find a job when making an emergency fund. In some industries and during downtimes it can easily take 1 year to find a job. I wouldn't buy another house without 2 years worth of emergency cash.
    – HenryM
    Commented Aug 7, 2020 at 14:27
  • So it looks somewhat moot then because 10% is about what a conservative investment in the S&P returns (historical average of course). Actually the stock investment would be better because of the compounding effect.
    – sw1337
    Commented Aug 7, 2020 at 15:23
  • The math is still worth doing. And keep in mind, the presumption I made in my own decision was that the cash was not invested in the market, it was sub 1% emergency fund money. The approach is different between the two, but knowledge is power.
    – JTP - Apologise to Monica ♦
    Commented Aug 7, 2020 at 17:37

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