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!