Many of us have or will be pitched on a home mortgage refinance as the interest rate environment changes, but I want to give you an alternative view that considers more than just the math before you decide to move forward.
The problem with the traditional “break-even” refinance analysis…
Typically, when you’re deciding about a mortgage refinance you are trying to save cash — monthly cash flow that is. Often a mortgage refinance happens because the total amount of the payment (including taxes and insurance) are suffocating your cash flow, but the difference saved on a monthly basis rarely seems to make a difference once the dust settles. Seldom is the focus on the overall amount of interest you will pay on the loan because with a 15 or 30-year loan you have as many years before that amount of cash has been actually spent.
Let’s look at an refinance example…
In an effort to justify the refinance decision to save monthly cash flow a very common calculation called the “break-even” analysis is used to effectively tell you how long before you recapture the cost of the refinance.
Let’s say Bob and Susan currently have a 15-year home mortgage at 3.25% with $175,000 left on the loan. Their monthly payment of principal and interest is $1,405. They are trying to decide whether they should refinance this loan at 2.75% and save $189 per month in principal and interest payments. Although the total cost of the refinance will be about $4,500 when it is all said and done they are strongly considering moving forward.
In this hypothetical example, what should they consider? If they consider only the break-even analysis, they will divide the monthly savings (of $189) into the total cost of the refinance ($4500) and arrive at 24.04 — or 24 months. This is the time it will take for them to recapture the cost of the refinance. Many times this solution is framed by mortgage brokers saying if Bob and Susan plan to stay in the house another 21 months or longer, then the refinance makes sense. But does it? How does the mortgage broker come to this conclusion without considering other factors? The most glaring would have to be the additional interest being paid since Bob and Susan have already been paying interest on a loan. (I know the whole point of “break-even” is not to consider the interest already paid, but bear with me as I finish my argument because when it comes to personal finance this is a very narrow analysis to use as the only factor in decision making.)
How much extra in interest are they paying to save $189 per month?
If you want to see this illustrated, you can check out this video, but I’ll save you the trouble and tell you they are paying $5,314 extra in interest payments to refinance. Whether this makes sense has to do with what else they could be using those dollars for???
Maybe they could contribute more to a 401(k)?
Maybe they could take a nice vacation?
Any number of things probably come to mind. The only point I want to make here is math is just part of the equation because there are so many factors to consider.
So the real question is “are they considering everything?”
We have to ask this because, often as humans, we allow cognitive biases to impair our judgment when it comes to evaluating alternative decisions. I’d like to introduce what I feel may be at least three cognitive biases impairing their choice to refinance. This is what I hope to help you avoid if you are faced with a similar decision.
If Bob and Susan move forward, is their decision purely based on whether they will continue to live in this home past the “break-even” point?
Does this correlate to the most financially sound decision for them considering the opportunity costs of paying extra interest over their entire stay in this home?
These are a few of the biases which could reinforce a decision to move forward…
Anchoring. Bob and Susan have been watching the news, reading papers and hearing from neighbors about the rise in interest rates. They subsequently search on the Internet to find out where home mortgage interest rates currently stand. They end up comparing theirs to what they’ve found. They determine their rate isn’t as low as the comparison rates and they should be paying a lower rate. The thought of “over-paying” for their mortgage gets anchored in their minds.
Bandwagon effect. This happens when Bob and Susan show up in their social circles and learn of other couples that have refinanced and gotten lower interest rates. Furthermore, they are told the process is quick and easy. They now feel compelled to at least talk with a home mortgage broker about their refinance options. After all, what harm can it do? Everyone else is doing it, right?
Confirmation bias. After meeting with a broker, Bob and Susan rely on all the information presented to them without doing any independent research of their own just because it falls in line with what they’ve been thinking all along — they are paying too much.
Does this sound familiar?
Although this is a hypothetical example, human nature is not much different. We get an idea stuck in our head about something. Next, it seems everything around us is reinforcing the idea and before we know it we’ve made a decision. Bob and Susan just “impulse-bought” another mortgage product for $5,314! Unfortunately, they didn’t fully weigh the costs of the decision in order to come to a reasonable determination about whether this was best for them.
So what should you do?
The natural question at this point, is “how does this affect me?” “What should be my choice faced with such a decision?” Although, I’d like to think a spreadsheet like the one I created is definitive it is not. (see above YT video link for a copy of my logic) And if you solely relied on it you would be lending yourself to confirmation bias — LOL!
In closing I’ll leave you with a few things to consider so you won’t find yourself making a similar mistake:
- Don’t do it just because everyone else is doing it. Look at your situation independently because it is impossible for you to know all the factors affecting others’ decisions.
- Ask yourself whether being rid of your mortgage sooner makes more sense or freeing up more cash flow sooner makes more sense. Essentially you can’t have both and you have to decide. This will be largely depending on your short, intermediate and long-term goals.
- Are you going to stay in the home? Chances are high that if you are going to move soon (in the next 2–3 years) a refinance doesn’t make sense. You probably won’t recoup the cost of the transaction in enough time unless there is a large difference in the interest rates (e.g. 1% or more).
- Are there other options to consider if cash flow is an issue? Perhaps you could downsize (e.g. sell) or rent for a while to get into a stronger cash position. Often saving interest payments isn’t something factored into our decision. However, the money you are sending to the bank could be getting contributed to your investment portfolio for a current tax deduction and earning market rates. I’ve done an entire video on the decision to pay off your mortgage or invest.
Whatever you decide, make sure you are considering all the factors — not just about the math.