I’ve been away for the past little while dealing with a death in my wife’s side of the family. Thanks to everyone for your notes of support — it is truly appreciated. Today’s post is a guest contribution from Mike of Four Pillars. Regular programming will resume shortly. Over to Mike…

I recently did an analysis on my mortgage to see if it was worthwhile to refinance it. According to my original analysis, it wasn’t since I would be more or less breaking even. If I did end up making any money it would have been because of a good call on interest rates rather than the refi itself. As an interesting side note – we found out the termination fee from both the mortgage company and our mortgage broker. The mortgage broker’s termination fee was $300 higher which I guess would be their commission for ‘brokering’ the new mortgage. Always check with the mortgage company for the details.

Mr. Cheap referred me to one of his earlier posts where suggested that a cheaper way to refinance was to make use of any pre-payment room to lower the termination fee. He points out that you can borrow the money, pay down the mortgage and then get a new mortgage for the original amount and use the cash difference to pay off the loan. Since the loan would be very short term, the interest should be minimal.

Let’s look at a simple example:

Joe has a mortgage for $150k at 5% interest, 5 year term and he is 2 years into the mortgage. He owes $100k on the mortgage at this point in time. His mortgage broker calls and offers a deal – for a $4,000 breakage fee he can get a new mortgage for 4%.

Joe does the math (without prepaying) and concludes that he would break even so it is not worthwhile. Then he gets a call from Mr. Cheap explaining how to lower the termination costs by borrowing some short term money. Joe can prepay $30k so he can lower the termination fee by $1200 to $2800. Even if he pays $100 in loan interest then his profit is still $1100.

Needless to say Joe is pretty excited and goes ahead with the deal.

However that night Joe gets another phone call from someone named Mike who points out that he left out an important number from his original calculation. Joe (and Mike) didn’t add the termination fee to the amount of the new mortgage. Adding $2800 to the mortgage will increase his interest costs by $336 (for 3 years) which lowers his profit to $760. Not bad, but it’s debatable whether it is worthwhile or not.

Blend and extend

“Blend and extend” sounds like a good recipe for a fancy drink. It’s hard not to be positive about a smooth sounding marketing line especially when there are no termination fees to worry about. But is it too good to be true?
A commenter on my blog gave some details about his ‘blend and extend’

In our case we were 2 years into a 5 year fixed at 5.09%. By blending and extending we brought our rate down to 4.81% (for 5 yrs)

and it cost us a mere $75 to take that option and the paperwork was 1 page or 2. No legal fees or termination fees required in blending and extending.

As I interpret this – the ‘penalty’ is that he just got a 5 yr mortgage with a well-above market rate interest rate. Right now you can get a 5 yr mortgage for just under 4% so the extra ~0.8% is the penalty. This is not to say that ‘blend and extend’ is a bad deal, but rather that it’s probably not any better than a normal refinance where you pay the penalty and get a lower rate.

Switch to variable?

Another strategy is to pay the termination fee on your long-term mortage and then go for a variable rate or 1-year deal. The rates are so low that this is very tempting. However, if you do this you are really just making a play on interest rates. If you guess right then you might save a lot of dough, if you are wrong then you might be better just leaving things well enough alone.

What’s your story? Have you refinanced lately? Share ALL the details and why you think you are saving money.

This article has 14 comments

  1. First – Best wishes to you CC and your family and sorry for the loss.

  2. We recently refinanced both our properties in a great deal. We were only 1.5 years into 5-yr fixed, one at 5.79%, one at 5.63%. Penalties to break were IRDs ($9400 and $5700).

    Our metrics for whether to go ahead were either (i) lower remaining principal balance (after the end of the original mortgage term), or (ii) ‘cash differential’ for our rental (we reduced our payments (due to lower interest) – so we compared the $ saved on monthly payments to the $ ‘extra’ on our mortgage balance.

    The ‘new’ mortgages I looked into were (all pretty ‘conventional’ with 15-25% annual prepayment):
    (1) a 2% cash back mortgage @ 3.9%
    (2) a straight 5-yr @ 3.65%
    (3) a one-year @ 2.95% followed by a capped 5-yr (something like 4.5%)
    (4) variable, with some assumed rate increases over 5 years

    After modeling a bunch of scenarios, option (1) was best since the cash back covered close to 65% of the break penalty. For our residence, we’ll come out on top $9700 after 3.5 years (even more after 5 years) – when comparing the principal remaining. For the rental, principal will be $15k worse, but we’ll see $21k in cash flow.

    In addition to the obvious $’s we save, we had two additional benefits from refinancing. (1) interest rate protection. We were able to lock in a further 5 years to protect against any near term inflation. (2) lower minimum payments – if jobs are lost etc.

    Keep in mind the only reason we will benefit is because we have maintained our pre-refinance payment amounts – if we dip down to minimum amounts we’ll be not better off (well, a little because of the cash back – but this comes at the cost of flexibility since we have to pay it back if we break again).

    ALL the details 😉

  3. We refinanced a couple of months ago with great success. We were 4 yrs into a 7 yr 5.31% term. Paid early termination fee of $1,946 and rolled it into 5 yr fixed at 3.75%, principal of approximately 165K. Over the 3 years of the remaining original term we will save about $6,600 in interest, net savings of $4,654.
    I think this all worked out because the termination fee was calculated on the bank’s posted 5 year rate and we were able to negotiate a subsantially lower rate for the new mortgage.

  4. Sampson – I agree, your deal is pretty good. 3.65% with a 2% cash back? That’s fantastic.

    Sounds like there are big differences with various institutions so it might pay to shop around (which I haven’t done).

  5. CC- sorry for your loss. Take your time coming back and do what you have to do. Best.

  6. On the topic of reducing penalty for breakage by prepaying I am unclear how to pay back the loan if a loan is needed in order to maximize the prepayment?

  7. Just an FYI, there aren’t any lending institutions that I know of that allow ‘blend and extend’ any longer. That was a thing of the past.

  8. Adam – thanks for the update. I didn’t realize that “blend and extends” were no longer offered. I wonder why?

    John – if you borrow to lower your principal amount then you have to get a new mortgage for an amount that is equal to your (recently lowered) mortgage plus the amount you owe for the loan.

    Ie if you owe $200k and want to terminate the mortgage – borrow $40k from somewhere, pay down the mortgage to $160k. When you get the new mortgage – borrow $200k. Your actual amount owing on your house is $160k at that point so you use the extra $40k to pay off the “reduction” loan.

    In the end you will owe the same as when you started ($200k) but will save on the termination cost.

  9. Thanks Four Pillars, but when you get a new mortgage at the original rate does the mortgage lender drop the extra amount( 40k in your example) into your account or how would that work?

  10. John, I can’t guarantee the specifics since I’ve never done it myself, but I believe that if you get a mortgage for an amount that is higher than the mortgage it is replacing (as in my example) the bank will give you a banker’s draft for the difference. I would assume you might be able to get it deposited into your bank account as well.

    You would have to talk to the lending institution to verify what your exact options are.

  11. @John, Its pretty much exactly how FP describes it. They can deposit the extra cash directly to your account.

    FP, its certainly worthwhile shop around. We tied to use a broker, but this time they weren’t much help. I think variable rates are much more attractive now than they were 6 months ago when we locked in. With rates on the rise, discounted variable rates are likely to show up pretty soon.

    I’ll reiterate that you really should get several confirmations regarding your breakage penalty. We were sorta screwed by our previous lender since every time we called, they gave us a different penalty (and it kept going up). Until you see the official payout statement – don’t trust what they tell you.

  12. FP – Not sure why they don’t offer it any longer. I imagine it’s because there would be a flood of people looking to blend and extend at rock bottom rates, meaning there would be quite a loss of revenue for the lenders. When rates are at the bottom, there is only one place for them to head – up. They have nothing to gain by allowing blend and extend at this point, only something to lose.

    There was a time when you could blend and extend every 6 months and average down your rate quite nicely.

  13. Just a comment on the $760 savings. While that may not be much you also have to consider that you are getting an additional two years at a rock bottom rate. If you are renewing in 3 years you will not likely get rates that we are seeing now.

  14. Sampson, just for interest sake with a 15 year amortization your effective interest rate with the cash back offer is 3.38% Hard to beat that for five years.