Refinancing – don’t make just the minimum payment

You’ve heard the ads: refinance now and save hundreds, even thousands, of dollars a year.

And it’s true. Let’s take as an example somebody who took out a $300,000 mortgage in the summer of 2009 at 5%. Principal and Interest (P&I) payments would be $1,610 per month. Suppose she now refis at 3.75% with no costs. The monthly payment would drop to $1,315, a saving of $295 per month, over $3,500 a year. Yippee!

The reason my website includes a mortgage calculator that shows the amortization table is to demonstrate just how expensive it is to borrow money over 30 years. It is rather like paying only the minimum on a credit card. In fact, a 30 year mortgage pays down just 3% of the principal in the first year.

The interest rate may be quite low, but the total interest bill still builds up over time. In the above example, total interest payments on the original loan over 30 years would come to $280,000!

By refi-ing as above, not only does the monthly P&I drop but so does the total interest over the life of the loan by some $40,000. On the other hand the loan is extended by 3 plus years. A 30 year old taking out the original loan would now be paying off the mortgage until reaching 64. As the Beatles didn’t say: “Will I still be paying my mortgage when I’m 64?”

Here’s what a good banker or broker should tell you: either switch to a 15 year mortgage, or make additional monthly payments in addition to the new P&I of $1,315.

A 15 year mortgage is currently about 0.5% cheaper than a 30 year. Now the monthly payment would increase by about $385 per month, but the borrower would save not $40,000 in interest but a staggering $155,000. And be mortgage free before the age of 50!

The effect of compounding is dramatic as the above example shows. Even though I know this, I was so astonished by the numbers above that I checked and rechecked them before writing. If you can afford the extra payments, a 15 year loan at current rates is outstandingly attractive.

Another alternative is to refi into a new 30 year loan, but use some of the savings to make additional payments each month. Use the calculator to see the impact, but an additional $100 per month would save $15,000 and reduce the life by over 3 years; an additional $150 per month would save $26,000 and 5 years; while adding the full savings of $295 per month (meaning actual payments would be unchanged from the current position) saves $50,000 and over 8 years.

One last word on mortgage rates. Don’t assume that rates will either go lower still or that they will necessarily stay this low for as long as the Federal Reserve is currently saying. If the economy does strengthen from here, interest rates my move up sooner than expected.

Conclusion: do refi if you haven’t already done so, and so put some of the savings into making more than the minimum payment on your loan.