When most people consider refinancing, they think of one of two things: reducing their monthly payment or reducing their interest rate. However, there is a third and potentially detrimental aspect to refinancing that many people do not consider.
And that is the fact that you are now replacing your existing mortgage with a new 30 year mortgage. So, if you are six years into your current mortgage and you refinance, you actually end up paying for 36 years instead of 30….if you are 11 year in, you end up paying for 41 years instead of 30…etc.
Now, the person who is simply looking to reduce their monthly payment is the person who will get hit the hardest here, but in many cases the person looking to take advantage of lower interest rates doesn’t come up too far ahead.
Let’s look at an example of someone who is looking to reduce their monthly payment. They are seven years into their 5% 30-year mortgage and are going to refinance at the current market rate of 5% by paying $5k in closing costs and taking out a new 30-year mortgage:
Currently
- At seven years into their loan, they have 23 years left (they will pay off their loan in July 2033)
- Their monthly payment is $1,831.22
- They will pay $205,416.14 worth of interest over the next 23 years
- They will make $505,416.14 worth of payments over the next 23 years
After Refinancing
- They now have seven additional years added to their loan and 30 years left on the new mortgage (they will pay off their loan in July 2040)
- Their monthly payment is $1,637.31
- They will pay $284,430.14 worth of interest over the next 30 years
- They will make $584,430.14 worth of payments over the next 30 years
So, while it may appear that they are getting a great deal by reducing their monthly payment by $193.91 per month, they are not only adding an extra seven years worth of payments onto their loan but they are costing themselves an additional $79,014 worth of interest over the life of the loan. Clearly a poor decision.
Now, let’s take a look at someone who is simply trying to take advantage of the lower interest rates. They are seven years into their 6% 30-year mortgage and are going to refinance at the current market rate of 5% by paying $5k in closing costs and taking out a new 30-year mortgage:
Currently
- At seven years into their loan, they have 23 years left (they will pay off their loan in July 2033)
- Their monthly payment is $2006.54
- They will pay $253,805.48 worth of interest over the next 23 years
- They will make $553,805.48 worth of payments over the next 23 years
After Refinancing
- They now have seven additional years added to their loan and 30 years left on the new mortgage (they will pay off their loan in July 2040)
- Their monthly payment is $1,637.31
- They will pay $284,430.14 worth of interest over the next 30 years
- They will make $584,430.14 worth of payments over the next 30 years
Again here, while it may appear that they are getting a great deal by reducing their monthly payment by $369.23 per month, they are not only adding an extra seven years worth of payments onto their loan but they are costing themselves an additional $30,625 worth of interest over the life of the loan. Clearly another poor decision.
So, next time you are considering a refinance, here are two things to consider:
1) Don’t just look at “how long will it take me to recover my closing costs based on my lower monthly payment” because that calculation is completely irrelevant in the scheme of things. Do an in-depth analysis or have your CPA perform an in-depth analysis for you to see whether or not the refinance will actually be worth it in the long run.
2) If you are actually just looking to take advantage of lower interest rates and you are not interested in reducing your monthly payment, you can win big time. All you have to do is find a lender who will give you a shorter-term loan that’s in-line with your current payoff schedule or find a lender that allows you to make additional principal payments each month. This way, you can keep your monthly payment the same and actually payoff your mortgage sooner while paying less interest over the life of the loan
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