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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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