As interest rates have dropped, many people are looking at re-financing their home mortgages. When you look at what the effect of a one or even two percentage point difference can make in monthly payments, it’s no wonder.
There are basically three methods to re-finance a mortgage with a lower interest rate.
- You can re-finance and have a lower payment while paying off the loan over the same amount of time. In other words, if you have 22 years left on a 30-year mortgage, you would take out a 22-year loan at a lower interest rate (and thus a lower payment). If you were to move a $200,000 balance in this manor from a 6.5% loan to a 5.25% loan, your payment would drop from $1,425 to $1,311, a savings of $1,368 per year. (This is after taking into account adding an additional $5,000 into the loan balance to cover points and closing costs.)
- You may re-finance and stretch out the terms to another 30-year loan. I’m not a big fan of this option since it pushes out the payoff of the debt another few years. The effect of a now-longer loan and the lower interest rate can dramatically lower the monthly payment, so for some people who are struggling to meet their mortgage obligation, this can make sense in rare occasions. By choosing this and using the same numbers as the first method your payment would go from $1,425 to $1,132, a savings of $3,516 per year. (Again after taking into account adding an additional $5,000 into the loan balance to cover points and closing costs.)
- You can re-finance at the lower interest rate and keep your payments the same, which shortens the length of the loan. For example, re-financing a $200,000 balance at 6.5% with 22 years remaining to a new loan at 5.25% while keeping the same monthly payment shortens the length of the loan to 19. (Again after taking into account adding an additional $5,000 into the loan balance to cover points and closing costs.)
As homeowners look at these options, some look at the monthly savings, while others look at the savings in interest over remainder of the loan.
In example #1, the amount of the interest paid over the next 22 years would be $138,580. In #2 the interest over the next 30 years would be $200,751. In example #3, the loan would have $117,593 in interest payments over the following 19 years.
The savings of over $20,000 in interest between option #1 and #3 is clear, but what is not as clear is how someone would do if they invested the savings in the payment.
Investing in a fairly safe mix of stock and bond funds that yields 8% per year would provide you with more money in investment accounts after 30 years than paying off the home loan early (ex: 23 years) and investing for seven years. A full examination of the results of different payoff strategies can be found in this PDF.
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