A couple weeks ago, I published a guest post about the value of a mortgage refinance from Lender 411. A reader named Kevin D replied with this comment:
I am disappointed to see this ad on this site. Sure, a refinance can be great but there is one glaring omission – your debt has now been extended! If I am 10 years into a 30-year mortgage at 7% and refinance at 4.5%, I just reduced my principal payment and extended my loan! Plus, there is hundreds (or thousands) in fees that could be used to pay down principal. It’s sad, people keep moving and refinancing and then find themselves 40 years into home “ownership” with 20 years left on their mortgage. I do not see how being a slave to debt for an extended time is assumed to be “immensely valuable”. Waiting until I have a larger down payment and getting a 15-year mortgage is far more valuable. That way, my money can work for me instead of for the bank.
Other than this post, this is a great site! Great content.
I responded to Kevin’s concerns in the comments, but I thought it would be helpful to write up a post on how to determine when it’s smart to refinance your mortgage.
Closing Costs Versus Interest Rate Savings
One of Kevin’s concerns was about closing costs. You should try everything you can to negotiate lower closing costs including shopping around. But be sure to compare the difference in rates. A no closing cost loan could have a rate that’s high enough to offset your upfront savings over the life of the loan. (On the other hand, this could be a good option if you won’t be keeping your mortgage much longer or if you’re contemplating moving but aren’t sure yet.)
When it comes to determining whether it’s smart to refinance your mortgage based on the closing costs, all you need to consider is your payback period. How long will it take before your interest savings covers your closing costs? If you’ll keep the mortgage for longer than this time period, it makes sense to refinance.
Here’s an example. Let’s say you have a mortgage with a current balance of $200,000 (originally $240,000) at 6% and 20 years left (out of 30). For simplicity’s sake, we’ll assume you’re refinancing using a 20 year mortgage with a 4.5% interest rate and $2,000 in closing costs. Your current principal and interest payment would be $1,439/month, but refinancing will bring your payment down to $1,265/month. That means you’re paying $174 less in interest per month. Your payback period is ($2,000/$174) 11.5 months. As long as you’ll be keeping your new mortgage for at least another year, refinancing saved you money in this example.
If your mortgage situation is more complicated than that (PMI, different terms, etc.), I’d recommend using the mortgage refinance breakeven calculator or the mortgage refinance interest savings calculator at Dinkytown.net. These calculators can handle more complicated situations and give you a better idea for your personal situation. Play around with the variables a bit and be sure to read the help at the bottom of the page if you’re not sure about something.
Consider Your Options When Refinancing
One of Kevin’s main concerns is extending the length of time you’ll be paying on your house. If you’re 10 years into a 30 year mortgage and you refinance with another 30 year mortgage, you’ll end up paying for your house over a total of 40 years. This isn’t good when you look at the total interest costs. (It would easily add another $60,000 in total payments in the example above.)
But just because you’re refinancing a 30 year mortgage you don’t have to use another 30 year mortgage. I alluded to this in my example in the previous section, but you can just as easily pick a term that’s similar to whatever you have left at this moment. If you’re 10 years in to a 30 year mortgage, you could choose to refinance with a 20 year mortgage. This nets you the interest savings without extending the total time you’ll be paying for your house.
Extending Your Mortgage Term to Cover the Rough Spots
If you’ve just hit some financial difficulties, refinancing your mortgage with a longer term than you currently have left can help you decrease your cash outflows. In my earlier refinance example, using a 30 year mortgage instead of a 20 year mortgage would take your new payment down to $1,013/month instead of $1,265/month.
I’m not saying this is the ideal situation because it will drastically increase your total payments if you take no further action. But it can be a legitimate option – especially if you plan to prepay your mortgage once you get back on your feet. In fact, it can actually set you up to be in a better position in the future simply because you’ll have a lower required payment. If you’re prepaying your mortgage and hit another rough spot, you can just drop back down to the minimum required payment.
Extending Your Mortgage Because You Have Better Investment Options
Finally, a riskier strategy would be to go ahead and refinance with a longer term so you can lock in a low interest rate. Then, instead of prepaying on your mortgage you invest your extra cash flow in something that will return a higher rate than what you’re paying on the mortgage.
This isn’t always possible, but with interest rates as low as they are today (easily in the 4-5% range) it can be a smart move. There are no guarantees, but even short term bonds have historically returned a little above 4%. A conservative stock/bond mix has a decent chance of beating such a low mortgage rate. (Disclaimer: Past performance is no guarantee of future results…)
Mortgage Refinancing Can Be Smart If Used Wisely
My overall point is that we shouldn’t ignore the value of a mortgage refinance simply because people can and do use them in dumb ways. You need to carefully consider your own situation and motives before dismissing a mortgage refinance as a good option for you. I have put up the Lender 411 ad and agreed to let them do a guest post because refinancing your mortgage is an excellent option for many people right now. Lender 411 offers a useful service that’s completely free to consumers and they do it in a user-friendly way.
Today’s interest rates are ridiculously low – you’d be foolish not to take the time to at least consider refinancing. If you want to shop around for rates, Lender 411 is a good option. But there are plenty of competitors in this business, so don’t feel limited to them.
Are you considering refinancing your mortgage? Do you think my examples were good? Did I miss something? Do you have a question I didn’t address? Leave your thoughts in the comments below and let me know!
good article! The idea of refinancing into smaller term mortgage is good and can save lots in interest charges
Thanks for your comment, Rakesh. Interest really adds up when you’re paying a mortgage over a long period of time. If you’re interested in paying off your mortgage faster, now would be a great time to refinance. By using the lower rates available today, you could keep your same payment by choosing a shorter term mortgage. Basically, you’d be able to pay off your mortgage early without actually paying anything extra.
Please expound upon the scenario when refinancing from 6.5% to 4.5% where there is 17 years left on the current mortgage and we plan to move in 2 to three years. We would like to lower our monthly payment which could only be done by getting another 30 year mortgage per our lender. We definitely plan to sale this house within the next couple of years. We want extra money to make some repairs on the home.
Hi, Cathy! Thanks for your question.
If you’re dropping from an interest rate of 6.5% to 4.5%, any loan term that is equal to or longer than your current term (17 years) is going to drop your payment. In fact, you could end up with a lower payment even by going to a 15 year mortgage because the drop in the interest rate is so large. What’s your current payment? Compare that to the payment this calculator can help you figure out: http://www.dinkytown.net/java/MortgageLoan.html.
You’ll certainly have a much lower payment if you choose a 30 year mortgage, but you won’t make much progress on reducing your principal over the next three years if you do that. The other problem is that closing costs will eat in to your savings (the difference between your monthly payments). If you can’t get your closing costs low enough, you’ll essentially be rolling the cost of your repairs into your mortgage balance. That’ll reduce any profit you’ll make when you sell the house.
Refinancing a mortgage actually operates on a number of levels. While most people are familiar with the concept of implementing refinancing for the purpose of direct capital relief; there are a number of other functions that refinancing can perform or allow for. In a broader sense, it’s important to understand how this tool, at the end of the day, offers an extra degree of precision and control. For homeowners in the right position: this can be a tremendously useful move to make. Refinancing can mean a lot of things – let’s discuss why it might mean more for your life and finances than you thought.