The Refinance Trap

When Larry wrote about his misunderstanding of refinance math, I dusted off an older entry to explain the trap he fell into. There are costs for refinancing mortgage loans:

Cost of the refinancing service: even if you get a “no points, not closing cost” loan, you are paying for it somehow. Sometimes the rate is higher than a mortgage with more fees. Sometimes the fees are added into your principal.

Time: suppose you refinance into a new loan after three years, you can be hurting yourself by setting the clock back. If you go from a 30-year product to another 30-year product, you are adding years to your payments. Are you really ahead? Most of the time, no. Also, interest is front-loaded, so your lender takes more interest from you in the first years.

Here’s some quick math:
(This is without taking any cash back.)
If you borrowed $325,000 at 6.125 percent, the principal and interest is $1975. Three years later, you reduce your rate to 5.125 percent, and you borrow what is due on your existing loan – about $312,000. The principal and interest is now $1699. Wow, you are saving nearly $275 a month. (That's $99,000 over the life of the loan.)

But, you are paying your loan for an additional three years. Add the 36 more payments of $1699; that’s $61,164. That cuts your savings some, doesn't it?

In the current rate environment, if you were going from 5 percent to 3.5 percent for a 30-year mortgage, it would look like this:

If you borrowed $325,000 at 5 percent, the principal and interest is $1745. Three years later, you reduce your rate to 3.5 percent, and you borrow what is due on your existing loan – about $309,400. The principal and interest is now $1390. Wow, you are saving about $355 a month. (That's $127,800 over the life of the loan.) Add the 36 more payments of $1390; that’s $50,040 less that you are saving.

When borrowers refinanced with cash back, they frequently were not ahead if they looked at the added payments. If you are further along on your mortgage than three years, your savings get slimmer and slimmer, if you have to set your borrowing time back to the 30-year mark. 

Real estate advice in the current refinance boom: If you can afford to shorten the term of your loan, you will be in much better shape. Otherwise, don’t rush into a low rate without looking at the whole picture. Do the math for yourself before going ahead with a mortgage refinance.