Wednesday, August 20, 2014

Details Of My Refinance

The biggest monthly expense in most people's live is their housing payment, be it rent or a mortgage. So if you are trying to reduce your expenses, it makes sense to start by taking a look at your biggest payment and see if there is any way you can reduce it.

In my case, I knew I could. I bought my house 10 years ago using a 30 year fixed rate loan at 6.375% interest. Since that time, interest rates have dropped considerably. I probably should have refinanced two years ago, but, for various reasons, I did not. Thankfully, interest rates have remained low and, this month, I finally completed a refinance. I switched to a 20 year fixed rate loan at 4.125% interest.

The Problem With A 30 Year Loan

Why didn't I get another 30 year loan? I've been involved in real estate investing for over a decade and one of the areas I invested in was foreclosures. When buying properties at foreclosure or just before they go to foreclosure, an important piece of information a potential buyer needs is the outstanding amount of the mortgage. That information is not publicly available, but, because the mortgages themselves are publicly recorded documents and they include the length of the loan, the original loan amount, and the interest rate, it's relatively easy to calculate this figure using loan amortization tables.

My rule of thumb was that if a 30 year mortgage was five years old or younger, virtually none of the principle had been paid back. Those first five years of payments go almost entirely towards interest. Now, this isn't strictly true, as we shall see, but it was close enough for my purposes while investing.
30 Year Amortization Chart

Given that I have been paying my mortgage for ten years, I had already passed the five year threshold and was making noticeable progress on paying down the principle. I didn't want to get a new 30 year mortgage and start that five year clock all over again. My age also played a bit of a role in the decision to go with a 20 year loan - I don't want to still have a mortgage while I am in my mid-70s.

30 Year Loan Vs. 20 Year Loan

Let's look at my rule of thumb and see how close it is to the actual numbers. For simplicity, we'll assume a $200,000 loan at 6.375% interest. On a 30 year loan, after the first five years of payments, the outstanding balance would be $186,950. (You can use an amortization calculator like the one found here to figure this out.) You would have paid off about 6.5% of the original loan amount.

So my rule of thumb wasn't too far off - very little of the principle has been repaid after five years. (From a foreclosure investor's viewpoint, it's actually more accurate because by the time a home goes into  foreclosure, the bank has already added on several months of late fees and other penalties which would also need to be paid off.)

Now let's look at a 20 year loan. Again, we'll go with a $200,000 loan at 6.375% interest. In this case, after the first five years of payments, the outstanding balance would be $170,837. You would have paid off 14.6% of the loan.

In other words, you would have paid back an additional $16,000 in that first five years. Of course, that comes at a price - your monthly payment on a 20 year will be higher than on a 30 year loan.
20 Year Amortization Chart

I Refinanced From A 30 Year Mortgage To A 20 Year Mortgage And My Payment Went DOWN

In my situation, I had a couple of things that were working in my favor that made this possible. First, of course, is that interest rates have gone down drastically since I took out my original mortgage. My original loan was at 6.375%. The rate on my new 20 year loan is 4.125%. Also, because I had been paying my original loan for 10 years, I had achieved a fair amount of principle repayment. My refinanced loan was approximately $36,000 less than my original loan. The result of these two factors is that I was able to refinance my 30 year mortgage to a 20 year mortgage and still see a reduction in my monthly payment of about $200!

Had I opted instead to get another 30 year loan at 4.125%, I could have saved even more money per month. However, I would have had to go through those first five years of almost no principle reduction again.  Let's see how that would have turned out.

Taking our hypothetical $200,000 loan again and a 4% interest rate (instead of 4.125%, just for simplicity), after five years the outstanding balance would be $180,895. I would have paid back 9.6% of the loan principle. Not bad. Definitely better than the 6.375% scenario.

Using a 20 year repayment, after the first five years, the outstanding balance would be $163,847. I would have paid back 18.1% of the loan principle. Wow!

By refinancing with a 20 year loan instead of a 30 year loan:
  • I'm repaying my principle (or, to put it another way, building my equity) almost twice as fast
  • I'm still saving over $200 a month compared to my original loan payment
  • My home will still be paid off completely at the same time it would have if I had not refinanced


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