Tuesday, September 7, 2010

The Hidden Cost of Refinancing

With mortgage rates at record lows, mortgage refinancing is starting to get a second look from recession weary homeowners.  For those whose credit rating didn't take a hit over the past few years, the prospects of lowering ones interest rate and monthly payments is a very tempting proposition.  However, there is one huge factor that most people don't take into account when doing the refinancing math.  Not taking it into account can literally cost you tens of thousands of dollars if you are not careful.

Refinancing a mortgage restarts the clock on your mortgage.

Let's say that you took out a 30 year mortgage 10 years ago.  Obviously, that means that today you have 20 years left on your mortgage.  Now let's say you decide to take advantage of the record low mortgage rates that everybody is talking about by refinancing into another 30 year mortgage.  That means that instead of making payments for another 20 years, as you would on your old mortgage, you will be making payments for another 30 years. 

In total you will be making mortgage payments for 40 years:  10 years of payments on the old mortgage plus 30 years of payments on the new one.

[Of course, this assumes that you continue to make just the minimum payment on your mortgage.  However, given the fact that a lot of people refinance to reduce their monthly payment, this assumption likely will hold for those people.]

Now you might think that you will still come out ahead because the payments are smaller and because the interest rate is lower.  The only way to find out is to look at the numbers:

Consider a 30 year fixed rate mortgage of $300,000 at a 6% interest rate.  Let's assume that you decide not to refinance it over the life of the loan.  If you make the minimum payments for the life of the mortgage, after 30 years you will have paid a total of $347,514 in interest.

Now let's assume that instead of keeping your mortgage for the full 30 years that you decide to refinance it after 10 years of making the minimum payment.  You refinance your mortgage into another 30 year mortgage but this time you get a 4.5% interest rate.  Now let's say that you continue to pay the minimum monthly payment for another 30 years until the loan is paid off.  Under this scenario, you would have paid $373,783 in interest of the 40 years of the combined loans.  That is $166,895 for the 10 years of the first loan and $206,888 for the 30 years of the second loan.  That 1.5% savings has cost you $26,269.

The following table summarizes the amount of interest you would pay if you refinanced after anywhere from 5 to 10 years:

Interest, First LoanInterest, Second LoanCumulative Interest
30 Years 6%$347,514$0$347,514
5 Years 6% / 30 Years 4.5%$87,082$230,050$317,132
6 Years 6% / 30 Years 4.5%$103,696$225,954$329,650
7 Years 6% / 30 Years 4.5%$120,005$221,607$341,612
8 Years 6% / 30 Years 4.5%$135,987$216,992$352,979
9 Years 6% / 30 Years 4.5%$151,624$212,091$363,715
10 Years 6% / 30 Years 4.5%$166,895$206,888$373,783

As you can see, the fewer payments that you have made on your first mortgage, the better off you are refinancing into another 30 year mortgage.  In this example, the break-even point is somewhere between 7 and 8 years.  Obviously these numbers will vary based upon your specific situation, but you get the point.

Is there anything that a homeowner can do to take advantage of lower interest rates without ending up paying more in interest?  Here are two strategies that make sense from a numbers standpoint:

1. Refinance into a mortgage that has a shorter duration.

Rather than refinancing the remaining years of your mortgage into another 30 year mortgage, refinance it into a 15 year mortgage.  This provides two benefits.  First, the shortening your mortgage reduces the amount of interest that you will end of paying on it.  Second, the interest rates for a 15 year mortgage are usually less than those for a 30 years mortgage.  Obviously, this will save you money in interest as well.  The only downside of shortening the duration of your mortgage is that it means that your minimum monthly payment will be higher than an equivalent 30 year mortgage.  For some people, that is a deal breaker.  That is why I offer up a second strategy.

2. Refinance into another 30 year mortgage but continue to make the same payment that you did on your old mortgage.

If you do the refinancing right, your minimum monthly payment will drop.  However, most mortgages will let you make additional payments so that you can pay down the loan faster.  This allows you to pay off your mortgage early and avoid paying extra in interest.  Because the interest rate on your new mortgage is lower, you will end up paying less in interest than you would have under your old mortgage.  This also gives you the flexibility to forgo the extra payment should the need arise.

The bottom line is that refinancing can be a money saver, but only if you pay attention to the numbers.


  1. When we refinanced the first time, the mortgage brokers we talked to didn't just use this as a selling point - they simply couldn't wrap their heads around the concept. Since we were two years in to a 30-year mortgage, we finally decided on a 28-year mortgage.

    Possibly the brokers were thinking that most people sell before the end of the mortgage term. If you don't change the principal (by rolling in all kinds of refi costs) and you have a lower rate, then you're better off for a while even if you refi and restart the clock on the repayment period, since your interest costs per month are less. But at some point the cost of paying down less (and thus borrowing more for longer) will outweigh the benefit of the decreased interest. The longer you had the original mortgage, I would think, the sooner this happens.

    Relatedly, when we bought our next house, we were in a situation where we had some money (lets call it The Chunk) that we could use towards the house but wanted to invest instead. But we foresaw that perhaps one day one of us (by choice or not) might not be working or be making less. At that point, more for mental happiness than for sound financial reasons, we would rather put The Chunk towards the house, and be left with a small mortgage. So we looked for someone who would do two mortages on the house, one for The Chunk and one for the rest of the cost of the house. The thought was that, should we want to put The Chunk into the principal, we would pay off one mortgage and be left with the second one, which we would then try to fit into our budgeting. No one would do this for us. So our situation is that if we ever want to put The Chunk into the mortgage we would shorten the period of repayment, which doesn't really do what we wanted. We could then refinance, but we'll never get the rate we got then. The other option is to keep The Chunk somewhere safe and use it to pay a percentage of the monthly payment, and fit the other portion into our budget, but that has obvious drawbacks as well.

    The mortgage market just ain't as flexible or smart as you'd want it to be (and all this occurred before the whole housing / credit meltdown thing.)

  2. Actually I am working on a followup post talking about whether or not it is better to refi even if you plan to sell before the end of the term. On the one hand, you have to hold to refi'ed mortgage long enough to recoup your closing costs. On the other hand, you are paying less towards principal. Stay tuned!

    Regarding "the chunk", another option would have been to initially use it towards the down payment on your house, and then immediately take out a home equity loan for the same amount. Then if you wanted to reduce your monthly payment, you could use the money you took out to pay off the home equity loan. The downside of this is that usually home equity loans are at a higher interest rate and shorter duration than a first mortgage.