Refinancing: Doing the time warp

Posted by  on Aug 08, 2014

Refinancing tends to become a hot topic whenever interest rates drop sharply, but even without a drop in rates there is a significant potential benefit to be gained by refinancing.

This benefit is something that has long intrigued philosophers and science fiction writers: It is the chance to play with time.

Effectively, refinancing can allow you to either speed up or slow down time. Depending on your situation, either one can help you better manage your mortgage.

When to slow down time

In refinancing terms, slowing down time means stretching out the repayment period when you refinance. In many cases, this simply means taking your remaining repayment period and stretching it back out to a full 30-year mortgage. This can be especially useful in these cases:

  1. When you are having trouble making your payments. If you are in danger of defaulting on your mortgage, lowering your monthly payments by spreading your remaining balance over a longer repayment period can help save your home.
  2. When you do a cash-out refinance. If you plan to tap into some of the equity of your home when you refinance, you will be increasing your remaining loan balance. Lengthening back to the original repayment period can allow you to do this without increasing your monthly payments.

Lengthening your repayment period will typically cost you more interest in the long run, but it can be worthwhile if it helps you meet more pressing objectives.

When to speed up time

Speeding up time by refinancing simply means switching to a shorter repayment period. This is likely to increase your monthly payments, but this can be worthwhile under the following circumstances:

  1. When you want to minimize your interest rate. Shorter-term mortgage loans typically feature lower interest rates; so if finding the lowest rate is your goal, shorter is the way to go.
  2. When you can afford to shorten your payback period. Paying back a loan over fewer years lowers your interest expense in the long run; so if you can afford the higher monthly payments, this can be the most cost-effective way to refinance.
  3. When the spread between 30- and 15-year rates is especially large. The spread between 30-year and 15-year rates varies. Lately, this spread has been running between 80 and 90 basis points; and so far this year it has been as high as a full percentage point, which is unusually large. Refinancing to a shorter mortgage allows you to take advantage of the lower end of this wide spread.

Certainly, there is a big difference between the payments involved in a 15-year and a 30-year mortgage; but for most people who refinance, the leap is not quite so severe. People typically don't refinance until they are a few years into repaying the original loan, so if they started out with a 30-year loan, they usually have a shorter period ahead of them already.

For example, if you are seven years into a 30-year mortgage loan, you effectively have a 23-year loan ahead of you. This would make the leap to a 15-year mortgage less extreme, plus there are intermediate products such as a 20-year loan to consider. The point is, you have options other than refinancing to the length of your original loan, and those options can put time on your side.

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