Three
Rules of Thumb for Mortgage
Refinancing
by:
Stephen L.
Nelson, CPA
You might think that
deciding to refinance a
mortgage requires only a
quick comparison of loan
interest rates.
Unfortunately, that’s not
really true. Refinancing is
trickier than that!
Fortunately, three useful
rules of thumb can often
help you make sense of
refinancing opportunities.
Rule 1: Don’t Ignore
Total Interest Costs
You really want to use
refinancing as a way to
reduce the total interest
cost you pay. While that
sounds simple in principle,
it is sometimes difficult to
do. The interest costs you
pay are a function of the
interest rate, the loan
balance, and the loan term
period.
When people refinance,
they tend to focus solely on
the loan interest rate. But
they often don’t pay as much
attention to the loan term
or the loan balance.
When you use
refinancing—even refinancing
at a lower interest rate—to
increase your borrowing or
to extend the time over
which you borrow, you often
aren’t saving money.
Rule 2: Trade Expensive
Money for Cheap Money
For refinancing to make
economic sense, however, you
do need to swap higher
interest rate debt for lower
interest rate debt. This
calculation, however, is
tricky. To make an
apples-to-apples comparison,
you must look at the annual
percentage rate that will be
charged on your new
loan—this is the best
measure of the new loan’s
interest rate cost—and then
compare this to the loan
interest rate on your old
loan.
You don’t want to compare
interest rates on the two
loans nor do you want to
compare annual percentage
rates on the two loans.
Again, just to make this
perfectly clear: You want to
compare the loan interest
rate on the old loan to the
annual percentage rate on
the new loan.
When the annual
percentage rate on the new
loan is lower than the loan
interest rate on the old
loan, then you are truly
paying a lower interest
rate.
Comparing annual
percentage rates with loan
interest rates seems
confusing at first. But note
that you would pay only
interest on your old or
current loan, so that’s all
you need to look at in terms
of its costs. With a new
loan, however, you would pay
both interest and any
origination or closing cost
fees. The annual percentage
rate wraps the interest rate
charges and setup charges,
origination charges, and
closing cost fees into one
interest rate-like number.
Rule 3: Don’t Lengthen
the Repayment Period
Be careful that you don’t
extend the length of time
you borrow by continually
refinancing. For example,
one common rule of thumb
states that every time
interest rates drop by two
percentage points, you
should refinance your
mortgage. However, there
have been times in recent
history when following this
rule would have had you
refinancing your mortgage
every few years. This could
mean that you would never
get your mortgage paid off.
If you refinanced every few
years, you would suddenly
find yourself still 30 years
away from having your
mortgage paid. |
