The Wrong Thing To Focus On When Re-Financing

We re-financed last year as have many homeowners who are taking advantage of historically low rates.

One thing that I’ve seen in some of the discussions about re-financing is a focus on the wrong thing.  See if you can spot what’s wrong with the following hypothetical statement:

“Our current 30 year rate is 6% but we’re able to get our re-financed 30-year loan at 4.25%.  This will save us $350 per month!”

On the surface, this looks like great news all around.  Lower interest rate, saving more money, what could possibly be wrong?

Simple: The focus on the monthly payment is misguided.

In this scenario, you’re going from an existing 30 year mortgage to a new 30 year mortgage.  This means it’s thirty years from the re-finance date, meaning that your total time of paying the bank is thirty years plus however long you already spent on the original thirty year note.  If you’ve been paying for five years, that means you’ll be working on this loan for thirty five years.

On top of that, part of the ‘monthly savings’ that the hypothetical homeowner is so happy about comes, not from the lower rate, but from the fact that they’re spreading the remaining balance over additional years (in the example above, thirty years versus twenty five years).

When you’re re-financing, it’s my advice to look at how much time you have remaining on the existing mortgage, and strive to shorten it, or at worst, keep it the same.

In the example above where the homeowner has already paid five years on the original note, their new mortgage should be no greater than twenty five years.  Ideally, they should go for a fifteen year note.

This could mean that the homeowner might have to pay more than they did every month.  If you’re looking at only the bottom line, many will rule this out, even if they have the income to do so.  But the benefits are tremendous: You’ll apply a ton more toward principle and you’ll get done paying the mortgage that much earlier.  And your interest rate will be lower.

In the example above, going to a fifteen year mortgage might end up costing the homeowner an extra $150 over what they’re paying today.  If they can afford that, though, they shave a total of ten years off of the time that they pay on the house, and they pay a fraction of the total interest cost.

Now, if your payments are already stretched to the limit, fine.  Go ahead and get the thirty year re-finance, but instead of banking that extra money from the lower payment, keep your payment the same as what you were paying.  One hundred percent of that extra payment goes toward principle, so you’ll end up paying the mortgage off way faster, keeping with my goal not to exceed the term of your original loan.

In the example above, sticking with a 30 year note but plowing that ‘saved $450′ right back into the mortgage could have them paying the new loan off in, say, twenty years.  Add the five years from the original note, and they’re paying for a total of twenty five years, still way ahead of the original thirty year loan.

That’s five years less of stress!

If you’re in the market for a re-finance, great.  Just make sure to focus on the right numbers!

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22 thoughts on “The Wrong Thing To Focus On When Re-Financing

  1. > Simple: The focus on the monthly payment is misguided.

    So true. This happens a lot with car financing too. People think they can afford the lower monthly payment, but don’t realize how much they will pay in interest in the long run.

    My mother recently re-financed her 30-year down to a 15-year. Slightly higher monthly payment, but her target end date will be 10 years sooner. :)

    • Exactly. You should never answer the question “How much can you afford every month?” that the dealer will always try to throw at you.

  2. The type of mortgage people take on, as well as the interest rate and how they make payments, combine to serve as a big factor in people’s financial situation. It’s important to look at all of the numbers, consider in light of your income/cashflow, and truly think about how great it would be to have the mortgage totally paid off.

    • Very well put, the decision should factor in all the elements not just final monthly payment.

  3. Great reminders. The same thought process happens all the time with new cars both lease and purchases-focus on payments not total costs. It’s a fool’s game!

  4. It seems as though our society has been hypnotized into looking at the amount of a monthly payment instead of the overall cost for any product. Refinancing is an area where the total cost is greatly overlooked – great article!

    • It’s because society has gotten used to listening to the lenders who don’t want you to look at the big number of the loan but instead gear you toward the smaller amount of the payment.

  5. We are in the process of refinancing right now. The first thing we did, besides compare rates between places, was also get estimates of what app and closing costs were. After comparing that and rates, we chose our company to refinance through and decided on a 20 year mortgage. The lower rate of the 20 year vs. the 30 year, plus our current balance and being able to combine the HE loan and the primary mortgage (as long as our appraisal comes back favorable), ends up with our payment on the combined loans being the same; we were paying a little bit over on the HE loan. Previous tips from Money Beagle and other sources helped me to convince the hubby that shortening the mtg to 20 years, paying about the same, but a TON less interest was better than just looking for a lower payment. Now we are just waiting on scheduling the appraisal. Our area’s values have gone up considerably the past year (we’re in a very good neighborhood) so hopefully we’ll have enough equity in our home to keep from having to pay PMI on the combined mtg. btw – we considered 15 year, but that would have put us an additional $100 – $150 over our current payments, so we decided on 20 year instead. Rate was still very good.

    • That’s a great approach. It seems kind of a letdown because your payments really don’t change, but if you look at the difference in what you’re applying to principle, it definitely adds up quickly in your favor. If you see an increase in income, you can always add extra to your payment to shorten it to a 15 year loan anyways. Many people who advocate taking a 30 year loan take this approach, but I generally wouldn’t advise simply because most people aren’t disciplined enough to do this. Sounds like in your case, 20 year will be perfect!

  6. Man, you just lampooned my post on refinancing. :)
    I am planning ahead a bit and need to reduce my monthly cost as much as possible for a while. If I can plow those saving back into the loan, then I will do it at the end of the month.
    Our income will probably drop a lot this year so any expense reduction will help.

  7. Great post. I just had this discussion (argument) with a friend who was so happy he cut his monthly mortgage payment by about $85 with his refi. He was about 8 years into a 30 year, and the refi extended his term back out to the full 30 years. He also rolled all closing costs into the new mortgage AND he pulled out money for a vacation… Heck of a deal. He is now DEEPER in debt and will will be for longer.

    • Ugh, that’s no good at all. If nothing else he should have gotten a twenty year loan. No sense at all in going past the term of the original loan.

  8. We are in the middle of refinancing. We originally had a 5.5% loan for 30 years, and have been paying on it for two years. We are now getting a 3% loan for 15 years. Woohoo!!! This only adds a few hundred dollars to our mortgage with a net savings of $110,000 in interest.

    • That’s awesome. I love hearing how people take advantage of the low rates and do it in the most responsible way possible!

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