Do Savings on a Mortgage Refinance Make a Good Deal?

February 18, 2003 "I know you advise against responding to solicitations but the deal I have been offered is too good to turn down. It would reduce the rate on my mortgage from 7.75% to 6.5%, saving me $245 a month, and cost me nothing out-of-pocket. (My mortgage has a balance of $185,000 with 20 years to go). Can you tell me this is not a good deal?" No, but neither can I tell you that it is a good deal. I don�t know enough to make this call. Neither do you. But what I do know makes me extremely skeptical. You are not paying anything out of pocket because they are adding upfront costs to the balance. I know this because if the balance of the new loan was the same as the balance of the old one, the payment should decline by $258 rather than $245. The smaller payment difference indicates that the new loan balance is approximately $4500 more than your current balance. In other words, you are paying $4500 for the lower rate. The fact that you are borrowing the $4500 rather than paying it out of pocket does not change this at all. While this deal is not quite as good as it looks at first glance, it isn�t a loser. My refinance calculator indicates that you come out ahead if you retain the new mortgage more than 42 months. But does coming out ahead make it a "good deal"? You define it that way, which is exactly how the solicitor wants you to define it. Probably he paid good money to buy a list of mortgage borrowers with large balances and interest rates above 7%. This is a valuable list precisely because it is easy to demonstrate significant savings to the client, and make a substantial profit at the same time. If the applicant is focused solely on the monthly payment, you can make even more by rolling upfront fees into the balance. The problem with defining a "good deal" in terms of the savings from a refinance is that such savings depend on the rate on the old loan as well as the rate and upfront charges being offered on the new one. By this definition, if your old loan had a rate of 8.75%, the deal offered would be even better! This makes no sense. Your focus should be on whether or not you could do better dealing elsewhere. A "good deal" is a new loan that is priced as well or better than any other new loan that you can find in the current market. This is the same definition you would use if you were shopping for an automobile, a computer or a mousetrap. Using this definition, I don�t know whether your deal is a good one or not. I don�t know your credit score, how much equity you have in your property, whether it is your permanent residence, or what type of property it is. All these factors and more are relevant to what you could find in the marketplace if you shopped other loan providers. Until you do, you don�t know whether you have a good deal, either. Copyright Jack Guttentag 2003

Jack Guttentag is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Visit the Mortgage Professor's web site for more answers to commonly asked questions.

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