The low mortgage rate environment of recent years has created a refinancing bonanza, giving millions of consumers a chance at a"do-over" on their mortgage loans. However, even with low mortgage rates, homeowners should take care to make sure that loan refinancing works to their advantage.
On the surface, the refinancing proposition seems compelling, as the past decade has seen 30-year fixed mortgage rates drop from around 6 percent to 4 percent. Still, it takes more than lower interest rates to make refinancing work. The obvious hurdle that refinancing has to clear is the upfront closing costs, but it is the potential back-end cost of refinancing that can really neutralize the benefit of lower interest rates.
Why re-starting amortization can cost you
Mortgage loans are designed to be repaid over a set number of years, and when you refinance, it can restart the countdown to paying off your loan. Restarting the amortization of loan principal can be costly for the following reasons:
- Interest dominates early payments. A typical fixed-rate mortgage is designed to have uniform monthly payments throughout its term. However, while the amount of the payments might be consistent, a closer look reveals that the nature of those payments changes drastically over the course of the loan. Because the remaining mortgage balance is bigger in the early years of the loan than in the later years, you pay more interest on the balance in those early years. Thus, the early payments on a mortgage are predominantly interest payments, while the later payments are predominantly principal. When you refinance in the early years of a mortgage, you are essentially forfeiting most of the payments you have already made, because they have probably done relatively little to reduce your principal.
- You may have created a 35-year mortgage. If interest rates fall and you replace one 30-year mortgage with another 30-year mortgage after five years, you are likely to reduce your monthly payments. However, you might also have signed on to paying interest for an extra five years - effectively, you have created a 35-year mortgage. It is very important to look at the total interest expense of a potential refinance loan to make sure you come out ahead in the long run, not just initially.
These realities do not mean that refinancing is a bad deal, but simply that you have to look for ways to reduce the long-term borrowing cost rather than just reducing immediate payments.
Two ways to enhance the long-term benefits of refinancing are outlined below.
- Find a better-fit mortgage. Thirty-year mortgages may be the norm, but don't feel boxed in by that. Work with lenders to find loan terms that fit better with the remaining years on your mortgage rather than simply matching its original length.
- Accelerate payments. If you can't find a new loan that's a good fit with the remaining years on your mortgage, you can approximate the same thing by making accelerated payments on a longer loan. Just make sure doing this does not subject you to any pre-payment penalties.
Lower interest rates have created a terrific refinancing opportunity, and understanding the impact of refinancing on amortization can help you make the most of that opportunity.