Help a Reader: To Refinance or Not Refinance?

I recently received this email from a reader:

I have about $12k left in a student loan (projected pay off July 2013). I'm currently investing $0 in retirement (Dave Ramsey Plan), but will be contributing what I'm currently contributing to pay off my debt when I pay off my debt. My current home loan is 3.875%/20 years (only 6 months in, refinanced earlier this year), with a balance of 153k.

I squeezed $100 out of my budget this month, and given the current mortgage rates, I'm at a dilemma.

I can currently get refinanced to 2.75%/15 year, that would cost about $100 extra per month, but add about an extra $100 in equity per month, for a given difference of about 13k extra in equity over 5 years.

Should I put the extra $100 in my debt repayment, and then eventually into retirement; or put the $100 into my house equity via the refinance?

• Note 1: I do have an emergency fund (about 30k), and have some retirement (about 30k).


• Note 2: Re the refinance, the closing costs would be about $900, thus the total cost over 5 years (including closing costs, and extra payments), would be about 7k, but I would have about 13k more in equity. The way I view it is I'm spending 7k to get 6k in returns, almost doubling my money.


• Note 3: Re my student loan, it is at the typical 6% interest rate, but I'm projected to pay it off in about 9 months, so they extra $900 ($100 per month over 9 months) towards it wouldn't make too much of a difference in the long run (e.g., pay the debt 1 month faster)


• Note 4: I'm really reluctant to pay down my student loan with my e-fund. I really like the e-fund in place, and by not using it, it forces me to pay down my debt faster.


• Note 5: The only reason I'm considering refinancing is how low the mortgage rates have gotten. 3 years ago (when I bought the house), I got a 5.875%/30; refinance 6 months ago to a 3.875%/20; and now I can get a 2.75%/15. In theory, I would like to refinance after I pay off my debt, but the driving force is i) how low the rate is now and ii) what will the rates be in 2013 when I project to pay off my debts.

What is your advice for him?

Comments

[Stephen]

Seems like a clear "yes" to me. Even if you had to use your (quite healthy) emergency fund to cover the $900 closing costs, it looks like you can easily recover this money in August of next year by directing the money previously used for the student loan payment to your emergency fund. Given that your emergency fund is at $30k, I can't see any reason not to do this.
While I understand the reluctance to use the emergency fund to pay off the student loan (a 30% or so reduction is pretty large), $900 is relatively insignificant given the size of the fund.

[Tyler]

I've done some math on this, but here is what I think you should do. (My reasons are not as cut as dry as pure math.)

Pay off the student loans- its 6% and you can never walk away from it. Get that debt off your back asap. $12k at 6% can turn into a nightmare if something ever happened and you delayed payments.

Put money into retirement/ emergency funds. IRAs can be tapped if you ever needed to get access to it.

Then if you have the ability... refinance the house.

First, rates are unlikely to go up anytime soon so there isnt a major hurry. If they do go up drastically there are so many other issues out there it wont really matter that you missed saving 1% on 150k. Second, your rate is low and the marginal benefit of lower rates diminishes. I realize it could save you 15k over 15 years. I just think getting rid of the worst debt you have first and then gaining financial flexibility is worth more.

If life goes great for you over the next few years you can always prepay on the house. If life gets hard, you have debt you can walk away from and a nice safety net.

[Jim]

Refinancing sounds like a good deal here.

My only concerns here are :

What if rates go down to 2.5% in a couple months or 2.25%? Would you refinance again? You could be wasting money on closing via frequent refinancing. You pay $900 in closing today. But you just refinanced it 6 months ago too. What if you want to go refinance again in another 6 months. Then again in 6 months, etc? You're spending closing on each refinance and if you just turn around and refinance again you basically wasted that closing cost. I'm not saying its not worth it overall but you want to be careful about refinancing too frequently or you lose more and more via closing costs each time.

A 15 year loan will lock you into a monthly payment thats probably around $1050 for interest and principal. If you stick with your 20 year loan you'd be around $950 ballpark. If you had a 30 year loan you'd be a little under $700. THe one concern with a 15 year loan is that you're locking yourself into a large payment commitment. Is $1050 a significant portion of your income? How easily can you cover that $1050 cost? Do you have more than one income int he family and how well could you cover the cost if an income was lost? Just something to think about. I know Ramsey preaches that you should pay your house off fast, but you can also do that by getting a 30 year loan at say 3.25% and paying the extra money towards principal. Then if you run into problems like a job loss you're not stuck with a $1050 payment but have an easier to manage $675 payment instead.

[Luis]

When you do your numbers keep in mind that you will combine a % of your first refi closing costs with your new costs because certainly in six months you did not recoup the ROI entirely. I learned this from a commenter on a previous refinance help a reader post. So the basic question stands, how long do you intend to live in your current home?

[Kurt @ Money Counselor]

I would:
- Use cash from the emergency fund to retire the entire student debt immediately and be done with it.
- Refinance the mortgage, using emergency fund cash if necessary.
- Direct all newly freed up (from former student loan payment minus higher mortgage payment) monthly cash flow back into the emergency fund until it's at an appropriate level.
Now you're in a very sweet place, and it won't take long to get there: Debt-free except mortgage; extremely low cost, short-term mortgage; plump emergency fund.
- Once the emergency fund is rebuilt, direct the funds that were flowing into it to a Roth IRA.

[Ben @ Bedrock PF]

First and foremost, kudos on the impressive emergency fund. It appears you may have gotten a little off track, though. I would retire the student loan debt right this very minute. Call them up and pay it off! Then, if need be, build your emergency fund back up to 3-6 months of expenses. I personally wouldn't refinance the house at all. Get baby step 4 and 5 completed, then apply every stinking dime to baby step 6. When you arrive at baby step 7, you can look back and snicker at the rest of us schmucks that are still stuck on baby steps 2, 3 & 4. Good luck!!! ;)

[MerCyn]

First pay off the student loan.
Instead of spending the $900 to refinance, put it towards the principal on your current mortgage and add the extra $100 each month - or more, if you like after paying off the student loan and replenishing your emergency fund.
If rates go down even lower you can still consider refinancing.

[JimL]

To me, this is a non-brainer. Refinance as your payback period is less than a year.

[Jeremiah]

First - are you sure that the $900 number is accurate? Are you sure that includes insurance, and recording fees, and mortgage fees, and escrow fees, etc. etc. etc.?

If so, the refi is probably a good idea. Additionally, you will likely have a month without payments, which will make your cash flow break even point basically a month. Long term, short term and even cash flow all look positive on this. I would go this route.

With that said, I don't think that there is any big rush. Rates should stay low for a while, so if you wanted to wait until your student debt is paid off, there's no harm in that. I don't think waiting is bad or wrong...

My list would be:
1-refi.
2-keep emergency fund strong (IMO, 30k might be high)
3-Payoff student debt
4-Restart retirement funding (If you get a match, I move this up).
5-anything else. I wouldn't buy a car, or a suite, or a watch, or a vacation, etc. until these are done. 9 months sounds reasonable for a timeline, so I would encourage you to hold off on all other expenses until the above are done.

[Michael]

Thanks for all the comments. I'm still really, really reluclant to pay off my SL with my EFund.

I'm married with 1 kid, and probably another the way next year. I'm the sole income in the family. 30k in the bank makes me sleep better at night. Plus working towards paying of the SL is a great goal, and once I'm done, I can't wait to scream I did it!! Paying it off with the E-Fund seems like cheating.

[Erik]

I don't think people understand you approach to debt and money when everyone is suggesting you use your emergency fund to pay off the student loan. Leave that money alone. The only thing you should look into is putting that money into a ROTH IRA if you don't alreday contribute. If you move a few thousand of that a year into a ROTH, that money is still 100% available in an emergency at no penalty. (Only if you take out the gains is there a penalty).

My advice is stick to your original plan. Don't refinance and just keep paying extra on your student loan debt until it is gone in 2013.

You have probably been in financial diet mode for a while to get things in order. Once the student loan is paid for, up your retirement savings and make sure you put some money away for a family trip or some other family want like a car or home remodel project.

It will be a hard adjustment but you are like a dieter that is reaching their goal weight. You will need to remain diligent but need to figure out a way to balance spending and saving.

[Carl]

I have a radical suggestion for you based on these facts.
You are concerned about rising interest rates.
Short 10 year treasuries (the closest tracker to the mortgage market) in an amount that equates the loss in principle of the treasuries for a 1% rise in interest rates to the amount you would have to pay in additional interest on a mortgage if interest rates rise 1%. If rates go up, you make money on this bet and put it towards equity in your home. If rates go down, you lose money on this bet but take out a lower interest mortgage in 6 months when you cover your treasury short. It is essentially locking in today's interest rate on your mortgage without refinancing. You can use your e-fund to do this if you feel your job is stable until you finish paying off your student loans. Even if it isn't, the value of this bet shouldn't rapidly change, so you should be able to cover with minimal losses at any time between now and when you actually want to refinance when your debt is paid off. Alternatively, if interest rates do go up, you just pocket the profit and don't bother refinancing. You aren't locked into that in 6 months.

[Luis]

@ Michael

The closing costs I am getting for 2.75% O points is $2200 at my local credit union. Where are you getting your refi?

What is the gap between what you make and what you spend per month? If you are risk avert with your efund, wouldn't you be risk avert to increase your mortgage payment in case something should have to your single income? Why did you do a 20 year and not a 15 year refi 6 months ago? If you cannot start retirement contributions at this point in time, it makes us wonder what is behind your finances.

A Reader Profile would probably give you more insightful comments.

[RichUncle EL]

I understand your nervousness with your Efund as you call it, but if you were really on the Dave Ramsey plan you would be debt free asap. You have 30K in the efund, pay off the debt and you still have 18K. That is a lot of months of living expenses if you ask me. Now once you are student loan free you can build up the emergency fund again to 30K, while contributing to the 401K plan. I would hold off on refinancing till Jan or Feb as rates may go lower then. If they do not go lower, hey you can still shave off 5 years off your mortgage then which in the big picture of things is the real reason for the refi not the 1% rate savings. Also you can save a lot in interest because you can add the old student loan payment amount to the mortgage and be mortgage debt free in 10 years.

[JimL]

I would definitely do the refinance and payoff the student loan. It really would not take that long to build back the ER and would would clearly be motivated to do so.

[Michael]

I guess another follow up question would be how big is too big of an emergency fund? I know it is 3-6 months of bills, which would be around 20k for me, w/ cutting to almost the bare minimum in bills. Does that seem to high or low?

[Luis]

I would stick with 30k personally knowing that is where you feel comfortable and since your family is growing. Whatever decision you make know that it is between several good choices and do what speaks to you.

[Special_Ed]

You should make the move and pay off the student loan. Paying interest you don't have to pay makes no sense.

I would also do the refinance on the home. You savings on the refinance should be $33,211.80 over the life of the loan.

[Michael]

I've made the decision. I'm paying off my student loan. Thanks for all the help guys!!

[brooklyn money]

This was a great discussion and really demonstrates that even among very financially literate people (FMF readers) there is not always a clear cut/no brainer decision when it comes to personal finance.