The Truth About Refinancing Your Mortgage

There are many resources available instructing home owners that when interest rates go down it is beneficial to refinance your mortgage. Unfortunately, not all of the facts are explained, and in many instances the lure of the lower interest rate and lower monthly payment while very attractive,  can be quite deceiving.

One such resource is the online mortgage calculator. These calculators generally explain two things about your mortgage if you refinance. Firstly, how much you will save over the life of your mortgage, and secondly, how much you will save monthly.

One such calculator appeared on three different sites that claimed you could save over $78,0000 in interest on your $300,000 mortgage if you refinanced it from 6% to 4.25%. The payments were actually lowered by $283 a month.  This appears to be an incredible savings until you look at all of the facts. A closer look will reveal that these calculators are very misleading.  The calculator on all three sites asks you to input the penalty amount and closing costs that will be incurred when refinancing. Two of the sites go on to explain that these numbers are not used in the calculations and one fails to mention this fact completely.

When you sign your mortgage it is a contract for the term you select.  The lender expects to get that rate of interest from you during the entire term.  If you break the contract before the end of the term the bank will penalize you for any interest that they have lost. The greater of the Interest Rate Differential or three months interest is generally charged when you break your mortgage contract.  The IRD is normally calculated by determining the difference between a lender's posted rate at the time your mortgage was signed, and the lender's posted rate for a term closest to the time remaining in your term.  Lenders charge this penalty to ensure they are not losing money if you refinance your mortgage before the end of your term.  Although this IRD calculation is common practice among lenders polices do vary.  You should always contact your lender to get an exact penalty amount.

Another flaw with these online calculators and the numbers they project is that they are basing your interest saved on the full amortization of the mortgage.  This is deceptive. In the example used above, you will still need to renegotiate your current 6% mortgage at the end of its  term, just like you will still need to renegotiate the new 4.25% mortgage at the end of its term.  These calculators assume that you will always renew at the same rate which is highly improbable.  You will not save money refinancing your mortgage this way.  If you have a need to lower your monthly mortgage payment you can do so by refinancing, but you will not come out ahead.  You would be far better off consolidating your high interest debt during the refinancing of your mortgage.  It is then possible to substantially lower your total cost of borrowing.

If you have equity in your home refinancing to pay off high interest debt could very well save you thousands of dollars. There are also plenty of advertisements showing that consolidating your debts can save you a great deal of money every month.  Sounds like a good idea, right?  Not so fast.  Ensure your banker, or broker is fully explaining the savings found by refinancing.  Work with a mortgage professional who can analyze your debt and take the current balances, interest rates and payments of all of your debts and project what your total debt will be in 3 or 5 years with your current mortgage.  Compare this to refinancing and paying off all of your high interest debt.  There are four options to look at:

1.  Increase your monthly cash flow by having your current projected balance and your refinance balance the same after a 3 or 5 year term  This will leave you with the same amount of debt, but a lower monthly payment.

2.  Lower your total debt by keeping your monthly payment commitment the same with your mortgage and all other debt payments included.  This will not free up any cash on a monthly basis but your interest savings at the end of your 3 or 5 year term will be significant.

3.  A combination of increasing your monthly cash flow and reduction of the total amount owed at the end of the 5 year term.  This will provide some instant gratification with lower monthly payments while reducing the total amount owed at the end of your term.

4.  Extending your amortization period to the maximum 35 years to lower your monthly payment as much as possible.  This should only be done when lower monthly payments are absolutely necessary as the interest costs will be significant.

Everyone has unique financial situations, short term and long term goals.  Find a mortgage professional that you are comfortable with and fully explain your short term and long term goals.  Your mortgage professional will be able to fully explain the outcome of refinancing your mortgage and find a mortgage that meets all of your needs.  If you do not fully understand how your mortgage professional is arriving at any amounts ask him or her to explain in detail.  If you still do not understand, ask again.  Hopefully they are not using an online calculator.