Refinancing? Consider a shorter loan term
Julie Garton-Good, GRI, DREI

Okay. You're ready to take the refinancing plunge. You've compared the monthly payments, and realize that you can cut more than $100 off your monthly payment as well as save 1.5 percent in interest. So why shouldn't you do it?

There's one more item to compare before signing on to a new loan--the length of each loan. As the following example shows, your savings, if any, may be significantly reduced if you refinance for the same number of years as your present mortgage.

Let's say you're considering going from an 8.5 percent mortgage to a 7 percent mortgage (both 30 year). You initially took out the $92,000 loan approximately two years ago; and now the balance is approximately $91,000. Even though you're not quite sure how long you'll keep the property, you estimate it will be at least two more years.

When you calculate the difference in monthly payments, it's around $100. This would equal $2,400 in payment savings over two years. After subtracting the closing costs of $2,000 quoted you by the lender, you'd have a net savings of $400. Or would you?

After looking at the entire picture, you might be astounded to see that not only would you not save, you would actually lose money. The explanation lies in the fact that both loans are for the same 30-year loan term. And since your current loan has already chopped off two years of heavy interest, any new 30-year loan would start that process all over again, causing you to lose ground where your equity is concerned.

Here's why. Mortgages are set up under the principal of amortization. Simply put, the interest is heaviest when the loan balance is greatest. After four years of paying on the original $92,000 loan at 8.5 percent, it would be reduced to approximately 96.6 percent of its original balance. That would be $88,872. But even though the new 7 percent loan for $91,000 is at a lower interest rate, after two years with this new loan, the balance would still be at 97.9 percent of its original amount, or $89,089. By going back into the same loan term, you've actually lost $217 worth of equity out of your pocket. When you offset this against the payment savings of $400, we're only ahead by $183. In fact, when we consider that we may have to pay additional taxes to Uncle Sam come April 15 because there's less interest to deduct, refinancing into another 30-year loan will actually cost you.

What would be possible solutions? You might shop for lesser closing costs on the loan. But perhaps the best way to maximize savings would be to take a 20-year (or lesser-term) loan, instead of a 30-year mortgage.

The true bottom line is to ask the lender to crunch numbers like these before you commit to refinancing. It's the hidden figures, like lost equity, that can make or break your savings.