|Refinancing? Consider a shorter loan
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.