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To refinance or not to refinance

Chris Farrell Feb 3, 2012

Question:  I have the opportunity to refinance from 5-1/4 percent to 4-1/4 percent. The savings will be $249 a month, which we really need because we probably will need a new car next year. The payback for the closing costs (rolled into the refi) would take 2 years. However, there is a small chance we could be moving due to my job before 2 years. Should I take the lower rate to get the monthly savings or find the money for the car elsewhere? My wife’s and my credit scores are high — about 800. (Yes, Tess, I checked FICO per your constant reminding on the show.) Eric, Ringwood, NJ

Answer:  In thinking about your question my initial reaction was that the answer really lies in really figuring out what are the odds of your moving in two years. The greater the odds the less sense it makes to refinance. I would add that no matter what you decide to do (and I know this is easier said than done) that I would focus on setting aside even a few dollars a month for the future car expense.

I still believe that’s right. But the more I think about your question the more I’m drawn to a different way of deciding the issue. It’s all about weighing regret. 

Behavioral economists have shown that regret is one of the most powerful emotions in finance. It’s the pain and anger we feel when, with hindsight, we see that we made “a bad decision in the past and could have taken one with better outcome,” says economist Bruno Solnik at HEC-Paris, in a review of the literature. I’ve accumulated plenty of financial regrets over the years.

I’ve always liked this illustration of the power of regret. Harry Markowitz is a leading scholar of modern portfolio theory. He’s mathematically sophisticated. If you look at his scholarly work it has many equations. Yet he once said it wasn’t mathematical correlations and determining the efficient investment frontier that drove his retirement portfolio asset allocation decision.  “Instead I visualized my grief if the stock market went way up and I wasn’t in it — or if it went way down and I was completely in it,” he said. “My intention was to minimize my future regret, so I split my [pension scheme] contributions 50/50 between bonds and equities.”

You can’t pierce the fog of the future. But you can decide which unfavorable outcome you’ll regret the least. For example, let’s say you refinance and you move a year and a half from now. You’ll regret the decision, of course. I would compare that disappointing outcome to not refinancing and three years form now realizing you aren’t going to move and you missed an historic opportunity to lock-in a low mortgage rate. In both cases you’ll feel regret, but which regret gets you the most upset and which one the least.

After weighing your regrets I think the answer will be apparent.        

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