Refinancing isn’t just about getting a lower payment or even a lower interest rate. You can get a lower monthly payment but find yourself paying tens or even hundreds of thousands more over the life of your loan.
Any time you refinance from one mortgage to another with the same term, for example thirty years, you extend the time it takes to pay off your home–and that could mean paying more over the long haul. So you need to look deeper than just the difference in your payment.
Refinancing: A Case of Imaginary Savings
Some lenders calculate your new payment, subtract your old payment, and proclaim that the difference between the two is “savings.” But that’s not the way amortization works. You can create fake “savings” by refinancing from one mortgage to a new home loan with the exact same interest rate! And you know that can’t possibly save you anything. Try this in your favorite mortgage calculator:
- Start with a $300,000 mortgage at 6% (your current loan). You have a payment of $1,799.
- Assume that you’ve been paying on it for ten years. If you look at an amortization schedule, you’ll see that your current balance is $251,057.
- If you do nothing, you would pay $347,514 in interest alone over the life of the mortgage.
- Now, here comes the refi: Put in a loan amount of $251,057 with a 30-year term, and don’t drop the interest rate.
- Your new payment is $1,505, which is $293 less. But of course you haven’t actually saved any money, your rate is the same.
- However, it will take you a total of 40 years to retire the mortgage and you will pay an extra $110,278 over the life of the loan!
What Affects Your Refinance Savings
If you haven’t had your current mortgage very long, the damage done by lengthening its term is minimal. Suppose you have only had your current mortgage for two years, and suppose you can get a 5% interest rate at a cost of $10,000. Using a mortgage payment calculator, refinance calculator, and amortization schedule, you see that after two years, your balance is still pretty high–$292,405. Your payment drops by $229, you recoup your closing costs in 3 years, 8 months, and over the life of your loan you save $29,073. So the three things that affect your refinance savings are:
- Amortization
- Interest rate
- Closing costs
Amortization is primarily the amount of time you’ve had your current mortgage and your remaining loan balance, the interest rate is the interest rate you’re offered by a new lender, and the closing costs determine how long it will take for the monthly interest saved to pay for your refinance.
Lower Monthly Payment Is a Valid Refinance Goal
Even if your overall interest expense in increased by a refinance, that doesn’t mean it’s a bad idea. If you use the extra cash to pay off high-interest debt, invest wisely, or take care of financial emergencies, cash today is a lot more useful than cash tomorrow. Just go into your refinance knowing what you wish to accomplish and what your trade-offs are.