Should You Borrow To Refinance Your Home Loan?

By Pinyo, on April 6, 2009

I came across Borrowing 401k Savings to Refinance Mortgage at Trees Full of Money. The article was mathematically interesting, and it’s worth analyzing this because many Americans are in a similar predicament. Here’s the premise:

A couple wants to refinance their mortgage from a 30-year fixed at 6% APR loan to 15-year fixed at 4.5% loan, but they are upside down on their home loan. They need $15,000 to make the refinancing happens. What should they do?

I know that’s not enough information to work with, but this still makes for an interesting discussion. What I’ll do is walk you through a few steps so that you can make similar calculations for your own situation.

When Refinancing, A Lower Interest Rate Doesn’t Always Equal Saving Money

First, make sure that you are really saving money if you do refinance. It’s not enough to compare 6% to 4.5%. What you need to do is determine how much interest you’ll be paying if you keep the original loan versus the total cost of the refinanced loan (i.e., interest plus closing cost). To do this, you’ll need a mortgage calculator similar to this one. For example, let’s assume your original $300,000 loan is a 30-year fixed rate loan at 6% and you’re refinancing to a 15-year fixed rate loan at 4.5%

As you can see from the scenarios above, you could lose money by refinancing to a lower interest rate. In general, it’s more advantageous to refinance newer loans than older ones, because most of your money goes toward paying interest at the beginning of the loan.

However, it’s worthwhile to note (especially in the last scenario) that while you may be losing $7,000 it is still worth it for some people because you get to borrow $162,000 for 15 years at 4.5% versus for 10 years at 6%.

Should You Borrow Money To Help You Refinance?

In general, borrowing to refinance is not a good idea. This is especially true if your cash flow is limited.

However, we will follow along the example above, and assume that the couple borrows $15,000 from Lending Club at 9% APR. Using the same amortization calculator, we calculate the cost of this loan to be $17,172 — i.e., the loan incurs $2,172 in interest over the 3 years period.

The savings is even greater than before. But how is this possible? This is possible because the couple are paying a lot more in monthly payment during the first 3 years — specifically, additional $477.00 per month to pay back the $15,000 loan.

For example, in the 10 year scenario the monthly payment for refinancing a $251,057.36 loan at 4.5% for 15 years is $1,920.57 versus $2,282.82 ($1,805.82 to pay back $236,057.36 loan at 4.5% in 15 years, plus $477.00 to pay back $15,000 loan at 9.0% in 3 years).

* Remember the amount is lowered by $477.00 after 3 years once the $15,000 loan is paid off.

Again, it’s worthwhile to note that while you are saving money on interest, you are doing so at a price. The question you need to ask is if you can do better using the difference in payment for something else. For example, should you invest or prepay?

What If We Simply Prepay The Existing Mortgage?

Now, let’s see what happens we prepay the original loan instead of refinancing. For this exercise, I am going to use this mortgage prepayment calculator, and pay equal to the monthly payment of refinanced loan with borrowing above. According to the calculator

Based on the table above, it appears that borrowing to refinance is more cost effective than prepaying — at least with this set of numbers and assumptions. Your scenarios will be different and you would have to go through a similar calculation to see:

1. If you should refinance or not. The age of your existing loan, the difference in interest rates, and the closing cost will be the key factors here.
2. If borrowing to refinance make sense. The amount you have to borrow and the interest rate will make a big difference here.
3. If you are better off simply to prepay the loan.

And here are some general guidelines:

• Think carefully before you borrow money to do anything. When you borrow, you are guaranteed to lose the amount you pay toward interest. However, you are not always guaranteed a better return on investment on borrowed money.
• Usually, it’s better to take out a loan for a longer period at a lower interest rate. But this isn’t always the right choice. For example, I have about 9 years left on my mortgage and I wouldn’t want to refinance it into a 15-year debt.

I know this article is heavy on mathematics, but I hope you enjoy learning about the process.

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Pinyo is the brain behind Moolanomy personal finance blog and a few other web sites. If you like this article, please subscribe for free daily email updates.

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