Make Sure You’re Coming Out Ahead When Refinancing

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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Author Info

This post was written by David Dierking. David lives outside Milwaukee, Wisconsin and has been working in the financial services industry for over 13 years with a background in investments, accounting, and marketing. He earned his Chartered Financial Analyst designation from the CFA Institute in 2004 and was recently published in the Milwaukee Business Journal. You can also check him out at The Ultimate Fit Challenge

4 Responses to “Make Sure You’re Coming Out Ahead When Refinancing”

  1. Personal Finance Tips |  Sep 30, 2010 at 1:29 am

    Well i would refinancing can become a deal if the payback time of your invest is less if the payback time of any business i.e. if it is new business also then it would called as not a good investment.

    Stuart

  2. JoeTaxpayer |  Oct 01, 2010 at 1:57 pm

    David, let me offer the secret solution. The one you ‘almost’ mentioned here.
    Your example has 12 years left, right? When refinancing, take the new rate, but use the remaining time left. Calculate payment. This properly reflects the savings and can be used to calculate the breakeven on costs, if any.
    Then, of course, one should pay the payment they calculated and be done in 12 more years. As you suggest the “savings” on the new payment may just be the result of stretching out the loan term. Not good.

    But – as I say often, finance is personal. Before making the payment, one should look at their alternatives:
    Any high interest debt? Pay off the 18% cards, now. ASAP.
    You getting all you potential 401(k) match?
    You have a proper emergency fund?

  3. Credit Cards |  Oct 18, 2010 at 3:14 pm

    One should consider even the foreclosure charges with the old mortgage and the various fees that you would pay for the new mortgage. These two things often change the picture.