Interest-Only Loans and Annual Refinances
A few of my friends who own homes got into the habit of getting interest-only loans and refinancing them every year. Apparently there was some math that “made it cheaper” to refinance every year. Starting every year with a new loan didn’t seem like a good investment but I’d never really understood the math. Of course, with the drop in home values, LTV ratios decreasing and the drying up of liquidity, this fad has disappeared, but I always wondered how the math worked. I was too lazy to actually do it since I knew intuitively that it must be wrong.
Fortunately ace mortgage broker, Randy Johnson, send me an email with the math.
many homeowners will never burn their mortgages because they make poor choices, like continually refinancing into 30-year mortgages.
Assume that a homeowner started out with a $100,000 loan at 6.5% and that he has been in his home for 5 years. He refinances the existing balance to a new loan at 5.5%. If he is like most Americans, he looks just at how much he saves per month. He gets modest interest savings, $14,265, less if you deduct the costs, which I will ignore. But in choosing to make the new lower payment, he goes out to the lousy end of the amortization curve again. He actually adds 10 months to the total time payments are made, a total of 370 months. That’s why it never gets paid off.
It is much smarter to make the old payment he was paying. He afforded it for five years and he can keep affording it. This converts his interest saving into principal reductions. It shortens the remaining repayment time from 300 to 249 months and doubles his interest savings compared with the first option. Now he saves $32,377.
The most valuable opportunity, however, is to get a 15 year loan which also carries a lower interest rate, 5% today. The payment is about equal to the original payment plus $100. That reduces the remaining payback time to 180 months. The interest during this 15 year period drops by over 60% from what it would have been had no refinance taken place.
To summarize
Interest due in remaining 25 yrs without refinance $96,009
Interest if refinance and make lower payment $81,743
Interest if keep payment the same $63,632
Interest if move to a 15 year loan $39,690
The cost of refinancing is usually never zero. Even if you don’t pay for it, its somehow baked into the loan.
I strongly recommend Randy Johnson’s stellar book How to Save Thousands of Dollars on Your Home Mortgage. If you don’t know what Yield Spread Premium (YSP) or Paid Out of Closing (POC) means on a HUD-1 you definitely should read this book. If you own a home and don’t know a HUD-1 is then get your spouse to smack you and then go buy the book! I promise you’ll save thousands of dollars on your mortgage.
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. If you don’t know what Yield Spread Premium (YSP) or Paid Out of Closing (POC) means on a HUD-1 you definitely should read this book. If you own a home and don’t know a HUD-1 is then get your spouse to smack you and then go buy the book! I promise you’ll save thousands of dollars on your mortgage.![[del.icio.us]](http://images.del.icio.us/static/img/delicious.small.gif){kind=small}
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February 15th, 2008 at 5:32 am
How about doing a refi for the same total value and term as the orignal loan. This puts cash in you pocket. Then, make an immediate principle repayment for the excess cash generated by the refi (which should equal the principal payoff to date on the original loan). Then net result of this approach is to put you at the same point on the amortization/principle payout schedules as you were on the original loan with the same time left to finish the loan and a smaller monthly payment. Even better, continue to make the same monthly dollar payment as before and shorten the term of the loan. This method keeps you from returning to the high interest/low principle payments that occur in the early years of a loan.