Make Sure You’re Coming Out Ahead When Refinancing
By David Dierking
With rates currently at all-time lows, the boom in mortgage refinancing has continued to pick up steam. 30-year mortgages can be had for rates under 4.5% while many 15-year mortgages are going for less than 4%. If you’re considering an adjustable rate mortgage, you can go even lower than that.
Refinancing your mortgage has long been considered a money saving opportunity and in most cases it is. But you need to be careful to make sure that the refinance that saves you money on your monthly payment doesn’t end up costing you more money in the long run.
Take, for example, the individual who is three years into a $200,000 15-year mortgage locked in at a rate of 4.5%. This mortgage would yield a monthly payment of about $1,530 a month.
Now, let’s say that this individual could refinance their mortgage to a brand new 15-year loan at the current rate of 3.75%. Let’s also assume that this person does a traditional refinance without taking cash out for the remaining balance on the mortgage (which would amount to about $170,000 after three years of making regular payments). Refinancing the original mortgage to the new terms would drop the monthly payment to about $1,236.
Sounds like a no brainer to be able to knock almost $300 a month off of your mortgage payment, right? Not so fast!
With the original mortgage, the total interest that would be paid over the life of the loan would be about $75,400. However, being three years into the loan, about $25,000 of that interest has already been paid leaving about $50,400 in interest yet to be paid over the remainder of the mortgage.
Looking at the new mortgage and its new terms, you would find that the total interest paid over the life of the refinance would be about $52,500. That means that the new lower monthly payment comes at a cost of about $2,100 in additional interest that you would be paying until your loan is paid off. Not quite the sweet deal any more!
Many people look at two factors when determining whether or not a mortgage refinance is a good idea. First, they look at the change in monthly payment. This gives an incomplete picture because it fails to take into account how much it will cost you to get that lower payment. Second, they look at the payback period. This compares your closing costs for refinancing against the amount you’re saving on your monthly payment. For example, if closing costs are $1,000 and you save $100 a month on your mortgage, the payback period is 10 months. The lower the number here, the better.
Our example would probably pass the sniff test on both accounts. A $250 drop in the monthly payment is significant and if closing costs were about $1,000 you’re looking at a payback period of just 4 months to break even. Both measures though fail to consider the amount of interest paid. Look at it a little deeper and you’ll see that what seems like a good deal on the surface would actually end up costing you more money in the long run.
Mortgage rates are a fantastic deal right now and most homeowners will come out ahead if they’re able to refinance. Just do a little extra homework to make sure of it because not everybody will.
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