Refinance Misconceptions – No Penalty or Legal Fees?

This is an actual client example.  The penalty and legal fees are not accounted for.  Considering that IRD penalties can be quite large a proper example cannot omit the penalty.  The text that accompanies this example also does not mention any penalties or legal fees.  It would also be nice to see the balance of both mortgage after the same time period.

Refinance Misconceptions – Too Good To Be True?

As I continue to look at refinance examples and calculators on the internet I get further disappointed.   Most people in the industry do not present all of the information and false claims are made to the detriment of the consumer.  I would like to think these are oversights, but regardless consumers are being grossly misled.  

The example I am going to look at is a scenario that was sent to me from a bank mortgage manager.  This was an article that was finalized and published.  If you want to take a look it can be found here in Scenario 2.  I have removed the bank information and the name of the author from the example.   I have no desire to single out any one organization or person for what I see as bigger issue in the mortgage industry as a whole. 

The author is trying to demonstrate that if you refinance to a lower rate and leave the payment pretty much the same you can save big dollars.  Unfortunately saving money in this example scenario is impossible.  If you were to refinance in the this scenario rather than save $177,659.52 as suggested, it would actually cost you money.  The better course of action would be not to refinance.  I will demonstrate this with the author’s numbers, but I have cleaned up the math and the logic.    

Current rate:  5.45%

IRD penalty:  $16,380

Principal balance:   $254,696.87

Remaining term:   36 months

Remaining amortization: 33 years

Monthly Payment:  $1377.41

Total of payments for 36 months:   $49,586.75

Principle paid:  $9,104.70

Interest paid:  $40,482.05

Balance at End of Term:  $245,592.17 

New rate is 3.15% in a 3 year fixed

New balance is $271,076.87 (balance + penalty)

Reduced amortization to approximately 23 years

Monthly Payment:  $1,377.41

Total of payments for 36 months:  $49,586.75

Principle paid:  $25,271.33

Interest paid = $24,315.42

Balance at End of Term:  $245,805.54 

As you can see the same amount of total payments was paid over both 3 year terms.  Unfortunately the balance on the refinanced mortgage is $213.37 higher than the balance on the original mortgage.  Both mortgages have to be renewed at the same time so they will be renewed at the same rate.  More principle and less interest were paid in the refinance, but the penalty negated any savings that could be had.  Naturally if you are renewing with a higher balance you will end up paying more over the life of the mortgage.  

Where did the author come up with a savings of $177,659.52?  In the authors example it is assumed that the old mortgage rate of 5.45% would be for the life of the mortgage and the refinanced rate of 3.15% would be for the life of the mortgage.  This is an impossible assumption which is often made in examples and by refinance calculators.  I can understand calculations being off by a few dollars over the life of a mortgage in any examples, but $177,659.52 is outrageously unacceptable.  

The last sentence of the article is:  “If you have the discipline to keep your payment as is and apply your savings each month, the benefits are clear.”  The only benefit to anyone is to the bank or broker getting your business at your expense. 

If your banker or broker has demonstrated that you can save thousands of dollars by refinancing, question the math and the logic.  If you want an accurate, logical, unbiased evaluation of a refinance you are considering feel free to email the information to me at mortgagemath@debtfreeby43.com  I would be happy to help!

Refinance Misconceptions – Omitting Vital Information & Flawed Logic

*** Update   ***  I had brought the errors to the attention of the person who created this example and he explained that someone got hold of his rough draft and posted it to a website.  He did send me the "proofed" published article which you will find here. It still needs a bit of work and I will refute the claim of being able to save $177,659.52 by refinancing in my next post.

These are two examples I found on the internet.  These numbers were created by a mortgage representative from one of the big five banks.  The numbers that I have worked out and my comments will be in red.

So When is it Worth  Paying the Penalty?

There are a few things to take into consideration here. Can you make back your cost in interest savings? If not, is a lower monthly payment worth the difference to you? What is my amortization? (I will discuss the importance of amortization and IRD further below)   What is the difference in the outstanding balance?

Example Scenarios. There are so many scenarios available that I obviously will not be able to cover them all here so if you are interested in an additional scenario please contact me and I can run the numbers for you. If you want accurate numbers you can contact me.

Scenario 1

Current rate is 5.45%

IRD is $16,380

Principal balance of $260,000

Remaining term of 36 months

Remaining amortization of 33 years

Payment of $1377

Payment of $1377.41

Total of payments for 36 months = $49,572

Total of payments for 36 months = $49,586.75

Approximate interest paid = $42,510

Exact interest paid = $40,482.05

If we put into a 3yr fixed at 3.15%

New principal balance $276,380 (balance + penalty) No mention of legal fees.  I will assume the bank is paying them.

Amortized over same 33 years

Payment of $1120

Payment of $1120.11

Total payments for 36 months = $40,320

Total payments for 36 months = $40,323.95

Approximate interest paid over term=$26,118

Interest paid over term = $25,272.23

There was a monthly payment savings of $9,252 ($9,262.81) over the term and an interest savings of $16,392. So interest savings matched the IRD so you are no further ahead. The difference however is that you paid $9,252 less in payments to get here. The interest savings is irrelevant.  The client reduced payments over 3 years by $9,262.81 which is impressive.  What isn't mentioned is the outstanding balance at the end of the term is $15,736.11 higher than what it would have been before the refinance.  That is right, it has cost you $15,736.11 to save $9,262.81.  Not a good deal for anyone except the bank who has retained another client.

Say for example you only made up $14,000 of the IRD in interest savings. For many people, the cost of $2,380 over the next 3 years is worth having a payment that is less per month.

I went through this whole example before I realized that errors were made at the very beginning of the scenario.  The bank rep has used an original balance of $260,000 for the monthly payments but did not reduce the balance when the mortgage was refinanced to reflect 2 years of payments.  The new mortgage should have had an opening balance of $254,696.87 + penalty.  Not catching this means none of my numbers are totally accurate either.  It just goes to show you that you have to ensure the math and the logic behind refinances must be done properly.  I am disappointed that I didn't catch this earlier.  I will be addressing the second example later in the week.  You will find the difference in the results shocking.  The bank rep claims you will save over $165,000 and I will show you that it will actually cost you money for this transaction.

Refinance Misconceptions – Comparing Fixed to Variable and Extending the Amortization

So this example is incredible, I can save $2,330 a month.  Why wouldn't I do this?  What this example does not show is the penalties or legal costs.  Even with these costs included it will look like a good deal.  Taking a fixed rate of 5.5% over 25 years and changing it to a variable rate of 1.95% over 35 years will always bring the payment down, but it doesn't paint the entire picture or address the risk of a variable rate.

Refinance Misconceptions

The internet, newspapers, radio and television all have advertisements telling you how much you will save by refinancing your mortgage and consolidating your debt.  At first glance these offers can be very enticing, but I have yet to find any that consider all of the costs when showing examples.  The calculators and examples are all misleading.

I like to think that these are oversights rather than omissions to generate clients.  I have a list of 10 calculators or examples that I will critique, demonstrating why they are inaccurate and deceptive.  All examples are from the internet, but I will remove any thing that identifies where the examples came from.

I have also come across some inaccurate statements about mortgages, penalties and refinancing that I will share.

I do encourage people to refinance if it will benefit them.  Unfortunately some examples are painting  prettier picture  than reality.  If you are considering refinancing and consolidating debt be sure you are working with all of the information and  that the calculations are accurate.  If you are unsure about the numbers you have been shown in your unique situation feel free to email me at mortgagemath@debtfreeby43.com I will take an unbiased look at your situation and give you some accurate numbers.