Determining if refinancing a mortgage is right for you is relatively easy. If you’re going to stay in your home for awhile and can get a mortgage rate lower than your existing rate that drops your monthly payment, then it’s probably worth doing.
One of the many online mortgage calculators will quickly show how much savings is possible from a lower interest rate.
Refinancing a loan can cost a few thousand dollars, which can be paid upfront in cash or financed in the loan. Borrowers can also pay “points” for a lower interest rate.
The basic calculation
A main part of the calculation that homeowners want to know about before they refinance is how long it will take to recoup the loan fees in the savings in their new monthly mortgage payments.
For example, if they have a $200,000 principal balance on a loan with a 6 percent interest rate and have 25 years left on a 30-year fixed rate loan, their monthly payment of $1,288 will drop to $1,135 with a 5.5 percent interest loan. That’s a monthly savings of $153.
But the cost of the new loan is $3,000, and it will take 19.6 months to get the payback of the loan cost.
To get to that figure, the calculation is to divide the loan cost by the amount of monthly savings:
3,000 ÷ 153 = 19.6.
Living in the home for 19.6 months will make the refi worthwhile.
What the calculation misses
What it doesn’t often take into account, however, is that refis often extend the loan. While a lower interest rate will lead to paying less interest each month, it will lead to a lower payment on principal and more interest paid over time if a loan with 25 years left on it is refinance to 30 years.
Without understanding the extension of the term of the loan, the calculation overstates the benefits of the proposed loan, says Casey Fleming, a mortgage advisor and author of “The Loan Guide: How to Get the Best Possible Mortgage.”
The example above of the loan with a $153 monthly savings is for a new, 30-year loan at 5.5 percent interest from a 6 percent loan with 25 years remaining. The interest paid drops from $1,000 to $916 per month, but payment on the principal drops from $288 to $218 per month.
By adding five years to the loan, even if the homeowner sells the home in five years, they’ll still owe more than they would with the old loan, Fleming says.
It’s a simple way that lenders make more money on refis and sell more loans, he says, by extending the loan and having the consumer focus on the lower monthly payment. That focus can get people to pay more for cars, wedding rings and homes, he says.
“That’s how people get money out of your pocket,” Fleming says.
A better solution
Instead of recycling the loan’s life, Fleming suggests having an accelerated payoff on a refi and keeping the same number of years on the new loan as the old one. It will give a homeowner more equity faster.
In the example above, keeping the 5.5 percent loan to 25 years would still lower the monthly payment — but by only $60 per month to $1,228. It would take about 50 months to recoup the $3,000 cost of the new loan.
But the principal payment would increase from $288 to $311, and interest payments would remain what they would with the 30-year loan, at $916. Over time, the interest payments would drop and the principal would increase, as they would with any loan.
“I want people to stop thinking about ‘What is my monthly payment?’” Fleming says. Instead, they should consider all of the costs, including the payment, interest and building equity.
For some people, a lower monthly payment is their main goal, and that’s OK, he says.
“Most people are trying to save money,” he says. “Some people just need a lower monthly payment because they’re barely making money.”
But don’t fool yourself into thinking you’re saving more money by extending the life of your home loan, Fleming says.
“If their goal is to save money, they should know how much money they’re saving,” he says.
What to do with the savings?
If homeowners do extend their loan terms by a few years to get more savings in their monthly mortgage payment, they could take that savings and invest it somewhere if they’re not going to put it toward the principal payment and build more equity in their home.
They can put it in a savings account or invest it, though that’s unlikely to happen, Fleming says, especially with only $153 a month that may easily go unnoticed.
“Most people just go and blow the money that’s just the way it is,” he says.
But safely earning more than 5.5 percent interest on that monthly savings may not be as easy as it is with their new, lower home loan rate.
Can you get a 25-year loan?
While 30-year loans are common, the length of a loan can be set at almost any term a borrower wants, Fleming says.
If you’re five years into a 30-year loan and refinance it, you can refi into a 25-year loan. Just don’t expect an interest rate reduction until you get to 20-year loans, he says. There’s no interest rate benefit to getting a 23-year loan, for example, instead of a 30-year loan.
Borrowers can make payments any way they want, including extra payments each month, without penalty, to accelerate a loan.
The key, Fleming says, is to be sure to tell your lender what the extra money is going toward. Some banks may automatically put an extra payment toward the next month’s payment if a use isn’t specified.
Fleming suggests writing in the memo line on the check that the extra money go to “financial curtailment” to pay the principal.
If nothing is specified, the bank may put the extra money in an “unapplied fund” that will sit there doing nothing until you tell them what to do with it. If you’re trying to pay down the principal faster so you can own your home quicker, that would be a waste of your time. And with an accelerated mortgage, the goal is to speed things up.