Homeowners refinance their mortgages for many reasons. Chief among their objectives are to drop their interest rate in order to lower their monthly payments. Provided you are aware that any money you save each month may be offset by increased interest expenses over the life of your loan, you can make an educated decision about refinancing.
Restarting the Clock: How Refinancing Lowers Your Monthly Payment
Two components of your refinance work to lower your monthly mortgage payment. The first is a lower interest rate, and the second is stretching out your remaining mortgage balance over a new term, such as 30 years. Loan officers may provide you with a false of security by calculating your new payment, subtracting it from your current monthly payment and call that difference "savings." But that figure isn't exactly correct. Here's an example of "savings" that really isn't:
- You have a $251,057 balance on a $300,000, 30-year mortgage at 6%.
- You have been paying off that loan for 10 years.
- Your monthly payment is $1,799.
- Over the life of your loan, you will pay $347,514 in interest if you leave it alone.
Now, plug this into HSH.com's refinancing calculator: a new loan balance of $251,057, a new 30-year mortgage, and a rate of 6%. You'll see that if you refinanced that $251,057 at exactly the same 6% interest rate, you'd get a monthly payment of $1,505, or $293 a month less. There are no real savings since you are getting exactly the same interest rate, and you end up paying an extra $110,202 in interest over the life of your mortgage!
The Refinance Payment Tradeoff: When It's Worth It
Paying more over the life of your mortgage isn't necessarily a bad thing, as long as you are aware of it and the refinance is part of a larger financial strategy. For example, you could use the extra cash flow generated by refinancing to a lower interest rate to repay credit cards with high interest rates. You could also make sound investments that generate more income, or use the extra cash to pad your retirement fund.
Staying On Schedule: Refinancing
If your mortgage is only a couple of years old, and you can refinance to a significantly lower interest rate, lengthening your mortgage term inflicts only minimal damage. HSH.com's refinance calculator can help you see exactly what you're getting and what you're giving up when you replace your old mortgage. Those who are several years into their current mortgages can take advantage of the lowest mortgage rates and pay their loans off on time by either refinancing to a shorter term, such as 15 years, or prepaying their new loans. Take, for example, that same loan at 6% which you have had for 10 years, now with $251,057 remaining:
- Say you were to refinance it to new 4.5%, 15 year term.
- Due to the shorter term, your new payment is $121 higher, but your mortgage is repaid in a total of 25 years (10 + 15) instead of 30, and you save $85,974 in total interest costs.
- Or, you could refinance it at 5% for 30 years. Your monthly payment would be $451 less.
- If you prepaid your new mortgage using that $451 to reduce your principal each month, you could retire your mortgage in just over 27.5 years (10 years on the original loan plus 17.5 years on the new one).
- You save $54,830 in interest over the life of the loan.
Whether you concentrate on retiring your mortgage early or choose to lengthen your mortgage term in favor of smaller payments is a decision only you can make. The choice to extend a mortgage even into retirement is debated by many financial analysts, and it depends a great deal on your overall financial picture (how diversified is your portfolio? How much of your wealth does your home represent?), and your tolerance for risk. There is no right or wrong refinancing decision; there are only informed or uninformed choices.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.