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Refinancing Your Mortgage
by
Charles Lamson
After you have purchased a home and closed the transaction, interest rates on similar loans may drop. If rates drop by 1 to 2 percent or more, you should consider the economics of refinancing after carefully comparing the terms of the old and new mortgages, the anticipated number of years you expect to remain in the home, any prepayment penalty on the old mortgage, and the closing costs associated with the new mortgage.
Worksheet 1 presents a form to use when analyzing the impact of refinancing. The data for the Philipatos family's analysis is shown. Their original $80,000, 10-year-old, 10 percent mortgage, has a current balance of $72,750 and monthly payments of $702 for 20 more years. If they refinance the $72,750 balance at the prevailing rate of 7 percent, over the remaining 20-year life of the current mortgage, the monthly payment would drop to $564. The Philipatos plan to live in their house for at least 5 more years. They will not have to pay a penalty for prepaying their current mortgage, and closing and other costs associated with the new mortgage are $2,400 after taxes. Substituting these values into Worksheet 1 reveals (in Item 7) that it will take the Philipatoses 23 months to break even with the new mortgage. Because 23 months is considerably less than their anticipated minimum 5 years (60 months) in the home, the economics easily support refinancing their mortgage under the specified terms.
There are two basic reasons to refinance---to reduce the monthly payment or to reduce the total interest cost over the term of the loan. If a lower monthly payment is the objective, the analysis is relatively simple: Determine how long it will take for the monthly savings to equal your closing costs (see Worksheet 1).
If your objective is to reduce the total interest cost over the life of the loan, the analysis is more complex. The term of the new loan versus the existing loan is a critical element. If you refinance a 50-year loan that is already 10 years old, with another 30-year loan, you are extending the total loan maturity to 40 years. Consequently, even with a lower interest rate, you may pay more interest over the life of the newly extended loan. Therefore, you should refinance with a shorter-term loan, ideally one that matures no later than the original loan maturity date. (The example in Worksheet 1.)
Many homeowners want to pay their loans off more quickly to free up funds for their children's college education or for their own retirement. By refinancing at a lower rate and continuing to make the same monthly payment, a larger portion of each payment will go toward reducing the principal so the loan will be paid off more quickly. Alternately, the borrower can make extra principal payments whenever possible. Paying only an additional $25 per month on a 30-year, 9 percent, $80,000 mortgage reduces the term to about 25 years and saves about $30,000 in interest.
Some people consider the reduced tax deduction associated with a smaller mortgage interest deduction as a disadvantage of refinancing. Although the interest deduction may indeed be reduced as a result of refinancing, the more important concern is the amount of the actual after-tax cash payments. In this regard, refinancing with a lower-interest-rate mortgage (with all other terms assumed unchanged) will always result in lower after-tax cash outflows and is therefore economically appealing. Of course as demonstrated in Worksheet 1, the monthly savings should be compared with the refinancing costs to make the final refinancing decision.
Because lenders offer new mortgage products regularly, you should carefully check all your options before refinancing. Remember that when you refinance, most lenders require that you have at least 20 percent equity in your home, based on a current market appraisal. Many financial institutions are willing to refinance their existing loans often charging fewer points and lower closing costs than a new lender would charge, so be sure to check with your existing lender first.
*SOURCE: PERSONAL FINANCIAL PLANNING, 10TH ED., 2005, LAWRENCE J. GITMAN, MICHAEL D. JOEHNK, PGS. 215-217*
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