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.
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