How to Think About Mortgage Refinancing

It seems like everyone and their mother is refinancing their mortgages. Don’t let your emotions get caught in the hype. Here is a way to think about whether you should refinance, too.

The Brexit has affected global financial markets. With the turmoil, central banks are keeping a close eye on interest rates. The Wall Street Journal reported that it is unlikely for the Fed to raise interest rates soon. So I started thinking about my mortgage.

Choosing to refinance your mortgage can become complicated in a heartbeat. I was fortunate to get a 30-year mortgage at 3.25%, and to get a lower interest rate is difficult. If you want to refinance, consider the short-term and long-term consequences.

The Short-Term

When you refinance a loan, you are pressing the reset button. Getting a new 30-year mortgage means you have another 30 years of payments and interest. Yet, a lower interest rate will drop your monthly payment. You can create some breathing room and have extra money each month pay off other debts. You could also invest your extra money into retirement.

If you can avoid it, I don’t suggest refinancing for the short-term benefit. The long-term cost is the thousands of dollars of extra interest. Over the course of your life, refinancing becomes an expensive choice.

The Long-Term

Refinancing to a shorter loan isn’t a terrible idea. Getting a 15-year mortgage with a lower interest rate might get you out of debt faster. The payments could go up, but it would also save you thousands of dollars in interest over the rest of your life.

The downside of refinancing to a shorter-term mortgage is the loss of safety. The higher payments could put a strain on your monthly budget. Instead, you could use the money could for emergencies or other financial goals.

Example

Ideas are nice, but numbers make plans real. If a client were asking me for advice, my next step for them would be to find dollar amounts for their decision. Below is a situation without a clear answer but helps you understand the process.

Please note, I use round numbers for simplicity.

Let’s pretend you signed up for a $200,000 mortgage at 4% for 30 years, but it’s now 10 years later. Ignoring taxes and insurance, your monthly payment is $955. After 10 years, there is only $158,000 left in principal. If you decide to keep this loan, you will pay another $72,000 in interest over the next 20 years.

You find a 15-year mortgage at 3% interest rate. Because of your excellent credit score, the new loan raises your payments to $1,091. Over the next 15 years, the total interest is only $38,000. As for fees, it completely depends on who you are working with. Let’s assume this refinance will cost $3,000 in fees. Keep in mind, some mortgage lenders add their fees to the total loan so there’s nothing out of pocket.

This choice ends your payments five years earlier and saves you $31k (after fees). But the cost is $3,000 up front and paying $136 extra per month.

Right away, refinancing looks expensive and could put a strain on your monthly budget. Over the long-term, you own the home five years sooner and will have saved $31,000. In my opinion, I think refinancing in this situation would be worth it.

How Situations Get Complicated

This example uses two fixed-rate mortgages, and your situation might not be as simple. Other factors that could complicate your situation include:

  • Do you plan to sell the house before the mortgage paid?
  • How much other debt do you have? Any high-interest credit card debt?
  • Do you have a different type of loan (ARM, FHA, VA, Jumbo, Conforming, etc.)?
  • Can you afford the fees today?
  • What is your credit score?
  • If you don’t have enough equity, will you need a down payment?
  • Are you refinancing to fund a home improvement project?

These situations make the math–and the choice–more complicated. The free, online calculators I have found can make you frustrated. If you are serious about refinancing, find a mortgage lender and have them help you run the numbers. They do it every day.

Final Suggestion

Don’t refinance your mortgage just because you can get a lower interest rate. Lower payments are nice, but the trade-off is thousands of dollars more in interest.

If you are going to get a lower monthly payment, put that extra money to good use. You could put more money in your IRA and let it grow over decades rather than buying a new toy. Long-term thinking and decisions are almost always the better options.