Certified financial planner Wes Moss provides personal finance advice and accessible investment strategies. His guest post appears here weekly.
Earlier this year, I offered this advice on when it makes sense to pay off a mortgage early:
But what about refinancing your home? Fidelity Bank, a local mortgage lender, was recently offering 30-year fixed mortgages at less than 4 percent and 15-year fixed in the low 3 percent range. Those are incredibly good rates. But does that mean you should jump on the re-fi bandwagon? Maybe not…
When people consider refinancing they too often focus solely on the rate, without considering time factors.
Example: Let’s say you’re three years into a mortgage and can get a new loan that will cost $3,000 in closing costs and save you $150 a month. OK, that means you’ll break even in two years. That’s a good deal – assuming you will keep the house well beyond the break-even point.
But what if you are already eight years into a 30-year mortgage? Up to this point you’ve primarily been paying interest on the loan. Banks know that, on average, Americans own a home for five to seven years. That’s why your first few years of mortgage payments consist primarily of interest. That’s when the lenders make the bulk of their profit.
The deeper you get into a mortgage, the more principal you pay off, and the less interest you fork over to the lender. So your mortgage company would love you to take a loan, pay on it for four to six years, then refinance at a lower rate, thus re-setting the schedule back to the timeframe when they collect the maximum amount of interest.
That’s why if you’re not careful about refinancing, you could end up paying more interest over the term of your mortgage – even if the new loan carries a lower rate.
One way to avoid this trap — and truly save money — is to shorten the term of your new mortgage. By reducing the term from, say, 30 to 15 years, you’ll make fewer interest payments and likely get a lower interest rate.
To borrow a phrase we’ve all learned by heart, a shorter-term loan is “the biggest no-brainer in the history of the Earth.”
– By Wes Moss, for Atlanta Bargain Hunter