Refinancing a mortgage may seem like a practical move, but there are factors to consider before taking this seemingly straightforward step with your finances. Many borrowers are not fully aware of the negative consequences of refinancing a home loan. It’s not uncommon for the average home buyer to end up spending thousands more over time after refinancing than they would have if they hadn’t refinanced their loan.
When interest rates drop, borrowers flock to refinance their mortgages. Lower monthly payments or the ability to put more money toward a loan without it all going toward interest are almost irresistible motivators. If you’re still in the very early months or years of your mortgage, refinancing may be a great choice. However, for homeowners who are further along, specifically close to or past the 10 year point of a 30-year loan, refinancing may accomplish exactly the opposite of their financial goals.
When looking into mortgages, understanding how the numbers work over time will allow you to make smart decisions for your financial health. Amortized loans are set up so that, at first, the interest amount per month exceeds the principal, by a lot. Over several years, those numbers will switch, with the interest payment getting lower and the principal payment getting higher. On a fixed payment, the overall payment doesn’t change, so the borrower may not take much notice, but the more money going toward the principal, the closer you are to a $0 balance. Mortgage loans are heavily front-loaded with interest payments, so the bank gets paid the most at the start of a home loan.
Two of the most popular mortgage options are fixed-rate 30-year loan or a 15-year loan. People tend to opt for the 30-year loan because the monthly payment is lower, but what they don’t often realize is that the 15-year loan, with a higher monthly payment, can be a better option.
If you refinance a 30-year loan on a $400,000 home with an interest rate of 3.750%, your monthly payment is going to be $1,852.46. On your 60th month, your interest is $1,128.23, your principal is $724.23, and your balance is $360.309.40.
30 Year Mortgage Loan
Now imagine you have a 15-year loan for the same house, now with an interest rate of 3%, because 15-year loans have lower rates than 30-year loans. By month 60, paying 2,762.33 a month, your interest is $720.28, your principal is $2,042.05, and your balance is $286,071.17.
15-Year Mortgage Loan
You’ll pay off your loan much faster with a 15-year loan because a bigger amount from your payment will be going toward your principal, from the start. On top of that, the portion of your payment going toward your principal rather than your interest will grow faster than with a 30-year loan. Looking at the bigger picture, although you’ll have higher monthly payments with a 15-year mortgage (i.e. $2,62.33), overall you’ll be paying thousands less than you would with a 30-year mortgage and a lower monthly payment (i.e. $1,852.46). Don’t let the savings of a few hundred dollars a month distract you from paying a loan off quickly and saving thousands from interest by the end of it. Here are some summaries to compare:
30-Year Mortgage Loan
With a 30-year loan for a $400,000 house at 3.750% rate of interest, you end up paying an extra $266,887.10 by the time the loan is paid off.
15-Year Mortgage Loan
With a 15-year loan for a $400,000 house at 3.000% rate of interest, you only pay an extra $97,218.59 by the time the loan is paid off.
A 15-year loan is also strategic for unexpected income decreases: Let’s say you landed a well-paying job, and you decided to go with a 15-year loan because you could afford bigger payments. If you suddenly lost your well-paying job and decided to refinance with a 30-year loan with lower payments, you would be better off because you’d have a lower balance remaining on the home to pay off. Beware, this only works if you re-finance BEFORE you lose your job or AFTER you secure a new position in a similar field. Obviously, it will be difficult to impossible to secure a loan if you don't have a job or are starting in a new field.
Because loans are front-loaded with interest (with the bulk of your monthly payment going toward interest for the first years, rather than the principal), refinancing past the 10-year mark (120 months), basically places you back at square one in the game of loans. It takes time for the number to shift in your favor, and refinancing basically turns back the clock, setting you back from the point where your money will finally start to literally pay off your loan in earnest. When you refinance, the amount you pay in interest will jump back up and the amount going to pay back your loan will again be a very small amount.
While refinancing a loan might make the most sense to lower your overall monthly expenses, if you can afford to pay your mortgage you might not want to go back to having a huge interest payment once again where the actual principal loan amount is barely getting paid off. Or you may consider taking advantage of lower interest rates by refinancing a 30-year loan into a 15-year loan.
It’s a good idea to ask your Realtor for loan officer recommendations, Realtors know the best ones! And if numbers/loans just don't make sense to you - don't worry, you are not alone. Just be sure to have a good Realtor looking out for you and an experienced loan officer that can discuss your options with you.