You might think that deciding to refinance a mortgage requires
only a quick comparison of loan interest rates. Unfortunately,
that's not really true. Refinancing is trickier than that!
Fortunately, three useful rules of thumb can often help you make
sense of refinancing opportunities.
Rule 1: Don't Ignore Total Interest Costs
You really want to use refinancing as a way to reduce the total
interest cost you pay. While that sounds simple in principle, it
is sometimes difficult to do. The interest costs you pay are a
function of the interest rate, the loan balance, and the loan
term period.
When people refinance, they tend to focus solely on the loan
interest rate. But they often don't pay as much attention to the
loan term or the loan balance.
When you use refinancing--even refinancing at a lower interest
rate--to increase your borrowing or to extend the time over
which you borrow, you often aren't saving money.
Rule 2: Trade Expensive Money for Cheap Money
For refinancing to make economic sense, however, you do need to
swap higher interest rate debt for lower interest rate debt.
This calculation, however, is tricky. To make an
apples-to-apples comparison, you must look at the annual
percentage rate that will be charged on your new loan--this is
the best measure of the new loan's interest rate cost--and then
compare this to the loan interest rate on your old loan.
You don't want to compare interest rates on the two loans nor do
you want to compare annual percentage rates on the two loans.
Again, just to make this perfectly clear: You want to compare
the loan interest rate on the old loan to the annual percentage
rate on the new loan.
When the annual percentage rate on the new loan is lower than
the loan interest rate on the old loan, then you are truly
paying a lower interest rate.
Comparing annual percentage rates with loan interest rates seems
confusing at first. But note that you would pay only interest on
your old or current loan, so that's all you need to look at in
terms of its costs. With a new loan, however, you would pay both
interest and any origination or closing cost fees. The annual
percentage rate wraps the interest rate charges and setup
charges, origination charges, and closing cost fees into one
interest rate-like number.
Rule 3: Don't Lengthen the Repayment Period
Be careful that you don't extend the length of time you borrow
by continually refinancing. For example, one common rule of
thumb states that every time interest rates drop by two
percentage points, you should refinance your mortgage. However,
there have been times in recent history when following this rule
would have had you refinancing your mortgage every few years.
This could mean that you would never get your mortgage paid off.
If you refinanced every few years, you would suddenly find
yourself still 30 years away from having your mortgage paid.
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