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How to Refinance Your Mortgage, Reduce Payments, and Avoid Increasing the Total Cost to Own Your Home

Have you looked at mortgage rates lately? They are (once again) crazy low, with 30 year fixed rates averaging just a shade over 4%. I feel like I’ve been saying this over and over, but rates can’t get much lower than this, so if you’re looking to refinance refinancing your mortgage. now is a great time.

That being said, I wanted to shed some light on a possible downside of refinancing that many people overlook…

In the good old days of ever-appreciating property values, many people were treating their homes like piggy banks, and refinancing to pull out equity that they could spend on something else. Nowadays, the economic landscape has changed, and most people are refinancing to reduce their interest costs and improve their cash flow .

While a healthy chunk of the apparent cost savings associated with refinancing comes from getting a better rate, it’s also important to keep in mind that you may wind up resetting the mortgage clock when you decide to refinance .

Mortgage refinancing: an example

Consider the following…

Ten years ago, shortly after getting married, Bob and Sue took out a $240k, 30-year fixed at 6.5% APR. They’ve steadily made their required payment of $1,517/month (principal + interest), and their mortgage balance has shrunk to $201k (rounding off). If they now decide to refinance to a new 30-year fixed rate mortgage at 4.5%, their payment will shrink to $1033/month .

Wow! That’s great! They’re “saving” nearly $500/month. What’s not to love?

Well… The interest rate savings is only a part of what’s driving down their monthly payment. The balance is coming from the fact that they’ve reset the time horizon to 30 years from now. Instead of being mortgage free 20 years from now, it take them 30 more years — for a grand total of 40 years!

Let’s take a look at the underlying math… Consider that, had they kept the

original mortgage, they would have made $278k in total interest payments. Even with the mortgage interest tax deduction. that’s a huge chunk of money.

With the refinance, they paid nearly $134k in interest during the first ten years, and with the new mortgage, they’ll pay an additional $166k of the next 30 years, for a grand total of $300k in interest payments. Yikes! Even though the refinance greatly reduced their monthly payments, it wound up costing them $22k in additional interest payments .

Now consider what would have happened if they had used their heads, and shortened the term of their new mortgage. Given that shorter term mortgage typically have lower rates, let’s say that they manage to find a 20-year fixed rate mortgage for 4.25% (i.e. 0.25% less than the 30-year mortgage).

In this case, their payment would drop to $1,245/month. a savings of $272/month over their original loan. Not as good as with the 30-year option, but still quite good. And we’re not done yet…

In this scenario, they’d still be on the hook for $134k in interest payments during the first 10 years. But during the next 20 years (the life of their new mortgage) they’d paid just $98k in interest. That’s a grand total of $232k in interest payment — a $68k savings over their original mortgage scenario!

The point here is to not get wowed by the monthly payment. Run the numbers and figure out both your monthly payment and the total cost to own your home. It’s possible to reduce both. But if you’re not careful, you’ll wind up reducing your monthly payment while simultaneously increasing your costs.

Note : Yes, I totally ignored the cost to refinance, the payback period on these costs, etc. Those points are generally well understood, and I didn’t want to muddle the current issue with unnecessary details.

Published on September 16th, 2011

Modified on September 25th, 2011 - 14 Comments

Category: Credit

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