Today’s historically low mortgage interest rates are luring many consumers into increasing the amount that they will spend on interest over the life of their loans. It’s counter-intuitive, but refinancing a mortgage to a lower rate could leave homeowners worse off financially by actually increasing their total interest costs.
Fortunately, with knowledge and a solid financial plan, you can offset or eliminate entirely the impact of increased interest costs.
How a refinance can increase total interest costs
It is actually more common than you might think for consumers to refinance to a loan that has higher total interest cost (at least on paper). The reason is that the vast majority of refinance borrowers choose a loan that has the same term as their current loan — refinancing a 30-year fixed to a new 30-year fixed, for example. Despite a new lower interest rate and lower monthly payment, the added months and years to the end of that mortgage can significantly drive up the total interest cost of the new mortgage, assuming the loan is paid through the end of the term.
But are consumers making a mistake when they refinance to a new lower rate loan that has have a higher total interest cost? Not necessarily — and here’s why.
The time value of money
To compare only the difference in total interest cost between two loans is to ignore the single most important concept in finance theory — the time value of money, or TVM. TVM is actually a simple concept: a dollar today is worth more than a dollar tomorrow, and the reason for this is that a dollar today can be invested and can grow into more than a dollar. For example, if you invest $100 today in an account that earns 2% interest over a year, that $100 will be worth $102 a year from now.
TVM is an important concept in refinance because a refinance can create a stream of dollars in the form of monthly savings. A refinance can also cause the term of your loan to be extended, but those payments don’t occur for many years down the road, so there is plenty of time to invest your payment savings and make up the difference.
Invest your payment savings wisely
So, how much would your savings need to grow in order for a refinance to make financial sense? The answer depends on the individual circumstances of the two loans, but in order for an investment in anything other than principal reduction to make sense, your after-tax return should exceed the after-tax interest rate of your new mortgage.
Given today’s mortgage rates and historical returns in the stock market, that should be achievable with a long-term investment in a broad index mutual fund or a properly diversified stock portfolio. (This strategy would, however, carry some risk of performance of the stock market, which given the recent market volatility can be a concern for many.)
Make a guaranteed “investment” in your home equity
If you’re not big on risking your savings in the stock market, there are still investment options that will entirely eliminate the risk of increased interest cost. In fact, there is a guaranteed “investment” that will ensure that you pay your mortgage off sooner and save you significantly on total interest cost: paying extra towards your mortgage principal.
You can simply “invest” the difference between your current and refinance mortgage payments back into your mortgage with a monthly principal reduction payment. By doing so, you are essentially applying the same payment you currently make on your mortgage to your new refinance mortgage. This strategy will shave months and years off the term of your mortgage, compared with the current mortgage, and will ensure that you pay less in total interest cost over the life of your new loan.
Create your own term
Some think that reinvesting your entire monthly savings back into your new mortgage takes some of the fun out of mortgage refinance. No worries: $20 and a trip to your favorite office supplies store will get you a financial calculator, which will solve this problem. With a few calculations, you can figure out a principal reduction payment that would pay off your new loan in exactly the same number of months that your current loan has left on its term. And if calculators aren’t your thing, just ask your loan officer to calculate it for you. This solution will ensure you save both on your monthly payments and total interest costs.
Consider a shorter term
Not everyone can really commit to making additional principal reduction payments. If that’s you, you still have options. Today, many lenders offer fixed-rate loans of various terms including 25, 20, 15 and 10 years. You can ask your loan officer to tell you if you would qualify for a term of loan that would most closely match to the remaining term of your existing loan.
An added benefit of going with a shorter-term loan is that you might get an even better interest rate. Another nice feature is that you don’t have to worry about whether or not your lender will correctly apply you principal reduction payment to your mortgage.
So while it is true that a new refinance mortgage could come with a higher total interest cost than your current loan, you should not let the threat of higher interest costs hold you back from dropping your rate with a refinance. A little financial planning and thinking outside of the mortgage payment box can easily allow you to lower your rate and reduce your actual interest costs.