Matt Soladay
The mortgage refinance industry has been booming with the historically low-interest rates available in the past year. This has attracted many homeowners to refinance as it seemed like a no-brainer: lower interest rates = lower monthly payments = long-term savings (MAYBE).
The low-hanging fruit is a lower monthly payment; it’s the biggest reason people refinance. And it seems harmless, doesn’t it? Well, I am here to show you that there is more to refinancing the largest loan of your life. There will be a refinance cost of about 3% of the loan amount, but if you divide that cost by monthly savings, you will get your break-even point. However, the part that you may overlook is that the easiest way to lower your monthly payment is by extending the loan’s length. The banks will show you how much you save every month but may not point out that extending your loan will increase the number of mortgage payments on the back-end. Those extra 3 to 5 years of mortgage payments will eat into most of the savings you are enjoying.
How To Calculate The Cost of Your Mortgage Loan
Begin with your current home loan and look up how much your monthly mortgage principal and interest payment is; do not include escrow/insurance/taxes. You will be able to find this information on your latest statement. I will use the following details as an example of how to calculate the total cost of the loan:
Original Mortgage Terms:
Loan Amount: $350,000
Term: 30 years (taken out three years ago)
Rate: 4.25% (fixed)
Monthly principal + interest payment: $1,721.79
Once you know the monthly payment amount, which in this example is $1,721.79, then multiply that by the total number of months left on the loan. Since this 30-year loan was taken out three years ago, that means 27 years remain.
(Monthly Payment) X (# years left on loan) X (12 months)
($1,721.79) X (27 years) X (12 months) = $557,859.96
That is how much your current mortgage will cost you between now and when the loan is fully paid off.
How To Calculate Savings of a Mortgage Refinance Loan
Now is the time to calculate the total cost of two different offers. After three years of this original loan, your balance would be $331,520.17 based on an amortization schedule, and if closing costs of 3% are rolled into the new loan, the new balance for both of the offers will be $341,465.77.
Offer 1:
Loan Amount: $341,465.77
Term: 30 years
Rate: 3.375% (fixed)
Monthly payment: $1,509.61, which would be a monthly savings of $212.18 from the original.
Total cost of this offer: ($1,509.61) X (30 years) X (12 months) = $543,459.60
This would be a savings of $14,400.36 from the original. Which is not very much considering we are talking about half a million dollars here.
Offer 2:
Loan Amount: $341,465.77
Term: 25 years
Rate: 3.25% (fixed)
Monthly payment: $1,664.02, which would be a monthly savings of $57.77 from the original.
Total cost of this offer: ($1,664.02) X (25 years) X (12 months) = $499,206
This would be a savings of $58,653.96 from the original.
Most people will accept the first offer because it has a lower monthly payment. For many, that would be a mistake. A $44,253.60 mistake. That is the difference in the total cost of the two offers. The first offer includes five additional years of mortgage payments, which eliminates much of the benefit of the significantly reduced monthly payment. The second offer is for a 25-year term instead of the 30-year term, and that, paired with a slightly lower interest rate, results in huge long-term savings without increasing your monthly payment.
How to make a decision between refinance offers
The shorter your term, the less you will pay over the life of your loan. However, it is a balance between paying less over the life of your loan but not paying too much every month that you feel stressed financially. Many people prioritize the smallest monthly payment possible, which is precisely what the mortgage companies and banks want you to choose because you pay more interest to them and are more likely to refinance in the future.
It is important to keep in mind that if you focus entirely on a lower monthly payment, it will mean you could be missing out on tens of thousands of dollars of savings over the life of your loan, as well as having to pay a mortgage until an older age than you want. Think about how that could impact you, particularly as you near retirement.
Don’t make a large financial decision without considering the long-term effects of that decision.
When interest rates for a refinance are low like they are now, the best choice might be lowering the long-term (total) cost of a new loan, not just the short-term cost of the loan. All this can be done WITHOUT increasing your monthly payment amount as well. Make sure you ask potential lenders about terms less than 30 years that won’t increase your monthly payment. Consider a term length very close or shorter than the remaining years on your current mortgage. We turned down the 30-year term, and they counteroffered with a 25-year that will save us an additional $50,000!
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