There are two reasons for this. One, our calculator is designed for
the most common scenarios, it may not apply to everyone. Of course we
would like to add more bells and whistles (cash-out refis, etc.) as
this calculator becomes more widely distributed.

Two, from a financial theory point of view, when a institution makes
bond refunding decisions, it doesn’t matter if a 30-yr bond with 28
years remaining is refunded with a 28- or a 5-yr bond, as long as
there is sufficient savings, the savings is quantified by the
difference the fair value between the two bonds given the underlying
interest rate environment. But in reality, the refunding is more often
done with a maturity-matched (28-yr) bond, because the cashflows can
be more easily compared.

In the mortgage market this is tricky because a 28-year mortgage is
not available. So to make a maturity-matched cashflow comparison, we
assume that the mortgagor pays off the 30-yr mortgage after 28 years
(of course the mortgagor doesn’t have to, but from a valuation
standpoint this is treated identically). This amount is indicated in
the “Principal remaining after 28 years ($):” box, and the mortgagor
can see the month-to-month cashflow comparison (or “Savings per month
($):”) for the 28 years.

Because many people are focused on the “break-even period”, the
“Savings per month ($):” is misleading. One of the readers commented
that he/she would need to hold the loan for 20 months to “win”, this
is disregarding (among other things) the principal remaining after 28
years. You may need longer than 20 months to “win”, but the
expected life of a 30-yr loan is 7-10 years.

The refi calculator does of course take into account the optionality
and the expected life of the new mortgage. The denominator of the
efficiency formula is “loss of option value”, meaning the difference
in the option value of the outstanding and new mortgage. In the case
of this reader, $5,000 in closing costs may seem like a lot, but it is
less than 1% of the principal.

so to truly use this calculator, one should input a no cost refi at the term and rate being offered, then compare it to the same term and refi with the points and closing costs included and the presumably better rate being offered with having to pay those various annoying closing costs and discount points.

so sort of a two step process I guess…

(1) Find a no-cost offer with a monthly payment not more than what you are currently paying. Going from 5.75% 28-year to 5.25% 30-year with no upfront cost is a no brainer. If you keep paying what you currently pay, you will pay less interest and pay off faster, with nothing out of pocket for the refi.

(2) Use that offer as your baseline. Forget about your 5.75% 28-year. Suppose you already have a 5.25% 30-year. Now see if it makes sense to pay some cost for a lower rate.

Now my scenario is obviously a total no brainer – zero costs and major savings (other than the headache of going through the refi). But I’m rather surprised that this calculator would indicate that with $5,000 in upfront costs, a $230/month savings is given an obvious green light. Clearly, if the loan is held for 30 years it is a no brainer. But I thought this more sophisticated calculator would be able to have a different input for the length of time that you actually hold the new loan.

For instance, with 5k in upfront costs, I have to hold the loan for 20+ months before I ‘win’ (in a very unsophisticated analysis – ignoring tax consequences, interest on savings). The optionality of my old loan and new loan have to enter into this analysis, but I don’t see how this calculator is accounting for the fact that 5k in upfront costs can actually be a very bad financial decision in some circumstances.

I guess what I’m asking is, how does this calculator actually help? I just don’t see it, just like I don’t see how the DecisionAide calculators can ignore the option value of the mortgage…

Yet, I was really surprised by the results, and don’t know whether to believe them. In particular, it does not seem to adjust for the fact that the new mortgage may not be held for all 30 years (or 15 years) either.

For instance, I put in a current term of 28 years remaining, a rate of 5.75% and a new loan with a rate of 5.25% and a term of 30 yrs, all for a 625,000 loan. Even putting in 5,000 of ‘upfront costs,’ it continues to rate the refinance at 100% – go for it!

I’m actually nearing in on closing this exact scenario, but for $0 out of pocket and 0 points. If I had to pay $5,000 the hurdle would be rather high, and it would take around 2 years just to break even, ignoring the optionality of the mortgage to me the borrower. If rates drop in the next two years, it is the loss of that optionality that is critical – and a ‘hidden cost.’ Thus, what matters most is the length of time that the new mortgage is held. At present, the calculator will only let us use the same length of time (or longer) than the current mortgage. Without being able to adjust this critical detail, the optionality issue is not addressed.