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.