The Schwartzmans had purchased their house five years earlier using a $300,000 mortgage (30 years @ 4.6%). Their mortgage broker was pushing them to refinance, which would trim their monthly payments by about $150. However, starting a new 30-year mortgage (on the current $269,000 balance refinanced @ 3.6%) meant additional fees plus paying monthly interest for an extra five years of his life. In additon, Mr. Schwartzman knew that earlier mortgage payments carried higher ratios of interest to principal, and was reluctant to start that initial period over again.
Is refinancing at a lower rate worthwhile despite setting the mortgage back to square one?
Some financial questions are complicated, but the decision about whether to refinance at a significantly lower rate isn’t. Unless the Schwartzmans are planning on moving shortly, swapping loans and grabbing the much lower interest rate is a no-brainer. The necessary calculation is simple: What’s greater—the fees to refinance or the interest that will potentially be saved? Since refinancing costs usually run in the range of 1–2% of the loan, saving 1% in annual interest means the Schwartzmans will break even within two years.
If the annual interest savings are lower and the break-even point further out, it’s still often worth locking in a lower rate if there’s a payoff of fees within a few years. Every penny of savings afterwards is pure profit, while monthly payments will be lowered immediately.
Make it apples to apples
Mr. Schwartzman’s concerns about extending the life of his loan are unfounded because he can refinance into a 25-year mortgage. While typical home loans tend to be for 15–30 years, some lenders allow borrowers to select any repayment length of time. Mr. Schwartzman can swap his remaining balance ($269,000 plus $5,000 in fees) for a new 25-year loan at the lower rate. This way, the apples-to-apples comparison is staying with the current remaining 300 monthly payments of $1,538 (on the original 4.6% mortgage) versus the new loan’s 300 monthly charges of $1,386 ($274,000 @ 3.6% for 25 years.) In addition to having an extra $152 in his pocket every month, over time, refinancing will save the Schwartzmans $46,000 in interest!
Or turn a pineapple into an apple
In truth, the length of almost any 30-year mortgage can be shortened by simply sending in extra money every month toward principal repayment. Say Mr. Schwartzman refinances his outstanding balance into a new 30-year mortgage, but with the current lower rates. While he is obligated to make 360 monthly payments of just $1,261, nothing is stopping him from instead sending 300 payments of the same $1,386 mentioned earlier.
As long as he lets the bank know that the extra money is for principal repayment, he will be finished with his mortgage in the same 25 years and at the same cost as the prearranged 25-year mortgage! This flexibility is why I love long-term mortgages. Borrowers have the option of paying much lower monthly payments and extending the life of the loan, but they also can decide to pay it off quickly if they have the funds and desire to do so.
(Longer terms do tend have slightly higher rates so it’s not a perfect comparison though.)
A typical mortgage mistake
Many people get confused by mortgage math. The concern Mr. Schartzman has about “starting over” his mortgage and earlier payments being more costly is widespread but wrong. The only reason early payments tend to be stuffed with interest versus later ones is because the outstanding balance is so high at that point. An equal rate of interest is charged to the unpaid balance at all times, so the more money still owed, the higher the interest. But, assuming the same outstanding balance and interest rate apply, payment number one of a 25-year mortgage and payment number 61 of a 30-year mortgage are identical. This fact sometimes shocks even major investors and mortgage brokers, but run the numbers on a loan calculator and you will see it in black and white.
Just do it…Again
Assuming they aren’t moving soon and can get approved for a new loan, it’s a waste for the Shwartzmans not to refinance. The fees are generally rolled into the outstanding balance, so there are no out-of-pocket expenditures either. Besides a bit of a hassle for rate shopping and paperwork, refinancing at a lower rate is one of the best ways to save real money. And if rates fall further a few years hence, you do it again!