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Mortgage loan officers would lead you to believe the answer is an unambiguous “YES!”, but the answer is, as usual, more complicated than the slick bank salesmen will tell you.
There are sometimes good reasons to refinance, of course. If rates drop far and fast, then in the early years of a mortgage it may make sense to refinance. For example, if in the second year of a 30-year loan, you can refinance to drop an 8% interest rate to 4%, it probably makes sense to do so, assuming the closing costs are low and you intend to hold the mortgage for many years to come. But the longer a mortgage a held, the lower the effective interest rate, as more of the monthly payment goes to pay down the principal balance – this is called simple interest amortization, and is something of a misnomer that requires explanation.
Simple Interest Amortization
Far from simple, this mathematical equation determines the monthly payment and the percentage of it that pays interest versus principal each month. At the beginning of the loan, nearly all of the monthly payment is interest, and almost none of it pays down your actual loan balance (your “principal” balance). But as time goes by, more and more of the monthly payment goes towards principal – paying off the loan balance – and less goes to the bank in the form of interest payments.
See on the graph how the percentage of the monthly payment that pays down the principal balance changes over time? In the first year, it’s a small fraction; by 20 years in, about half your payment is going towards paying down the principal balance, and by the last year almost all of the payment is going towards paying off the loan balance.
Thus, the longer you have been paying the same mortgage, the lower the effective interest rate on that mortgage.
Resetting the Beginning & End of the Loan
Lower payments are attractive to consumers of course, especially when the payoff date seems so far away (to most of us 2038 versus 2043 are both just “far away”). But refinancing pushes the entire payoff process back; in four years from now when you go to sell the property, the balance of the loan will be that much higher, because you both borrowed more money to pay for closing costs, and because more of your monthly payments are going towards interest rather than principal.
But What About the Money I Save Each Month from Lower Payments?
How long do you intend to keep the property? If you want to sell the property within the next few years, refinancing for lower payments almost never makes sense. If you want to hold it for 10-20 years, refinancing may make sense, depending on how much lower the payments are each month, how far along you were in the original loan and how much closing costs would be on the new loan.
If there is any doubt whatsoever, don’t refinance. Lenders will always try to convince you to refinance, because they make all of their money in closing costs and in all the interest paid in the first half of the loan term. They will offer all kinds of incentives, from lower interest rates to folding closing costs into the loan to tempting you with cash for remodeling the kitchen, but understanding how their business model works by front-loading all of their profits will help you make a more educated decision about whether to refinance.
