Should You Borrow to Refinance Your Home Loan?

Trees Full of Money has an article about Borrowing 401k Savings to Refinance Mortgage. I thought the question was interesting , and it is worth analyzing this situation, because many people are facing the same scenario. 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 will do is walk you through a few steps below so that you can make similar calculations for your own situation. But let me start off by giving you some general thoughts on this:

  • Refinancing to a lower interest rate does NOT always make sense. You have to consider
    • the total cost of the loan, e.g., interest cost plus closing costs,
    • your cash flow, and
    • your overall financial situation
  • Borrowing more money to fix your debt problem is generally a bad idea

The Math

Figuring Out How Much Money You Will Save

First, make sure that you are really saving money if you do refinance. It is 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. 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%

Age of the original loan (years) Interest remaining on old loan Principal balance to refinance Interest cost of new loan Savings before closing costs
10 $180,620 $251,057 $94,646 $85,974
15 $110,612 $213,147 $80,354 $30,258
20 $53,828 $162,011 $61,076 ($7,248)

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% and lower your monthly mortgage payment.

Borrowing 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. The $15,000 is used to pay down the principal on the original loan to make sure the loan is no longer upside down and could be refinanced. 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.

Age of the original loan (years) Interest remaining on old loan Principal balance to refinance – $15,000 Interest cost of new loan + $2,172 Savings before closing costs
10 $180,620 $236,057 $91,162 $89,458
15 $110,612 $198,147 $76,871 $33,741
20 $53,828 $147,011 $57,594 ($3,766)

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 payments during the first 3 years — specifically, additional $477 per month to pay back the $15,000 loan.

For example, in the 10 year scenario the monthly payment for refinancing a $251,057 loan at 4.5% for 15 years is $1,921 versus $2,283 ($1,806 to pay back $236,057 loan at 4.5% in 15 years, plus $477 to pay back $15,000 loan at 9.0% in 3 years).

Age of the original loan (years) Monthly Payment, original Monthly payment w/o borrowing Monthly payment with borrowing
10 $1,799 $1,921 $2,283*
15 $1,799 $1,631 $1,993*
20 $1,799 $1,239 $1,602*

* 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 — your monthly cash flow. 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?

Prepaying Your 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

Age of the original loan (years) Monthly Payment, original Prepayment Amount Savings with 3 years prepayment
10 $1,799 $484 $31,856
15 $1,799 $194 $8,379
20 $1,799 N/A N/A

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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