How are these advantages possible AFTER a mortgage has been signed? Help needed as I’m trying to wrap my head around financial mechanisms – why is this a thing and under what circumstances/ conditions does a refinancing make the most sense to use?
In: 293
**To understand refinancing, you need to understand APR.**
APR is your annual interest rate, but it’s *applied* monthly. Say your APR is 1%. Every month, you take 1% of the total amount you owe (the *principle*) and *divide it by 12* (because there’s 12 months in a year. That is the interest you owe that month.
Say your interest rate is 1% and you owe $12,000.
Your interest for the month is 1% of 12k divided by 12 months.
1% of 12k is $120.
Divide that by 12 months and the total you owe is $10.
It gets a little tricky because, every month, your principle goes down and all of this gets recalculated. It’s such a small difference that it’s insignificant for the explanation.
**So now you understand APR, but why does this matter? The question was about refinancing.**
It matters because your monthly APR gets deducted from whatever your monthly payment is.
Lets refer to the loan from above.
Let’s say you’re making monthly payments of $11 on your $12000 loan.
But we just did the math and we know that your APR is $10 every month. That means *only $1 of your monthly $11 payment goes to your loan.*
You think you’re paying off $11 of your loan every month. You’re not. You’re paying $1.
That means next month, after paying $11 to the bank on your $12000 loan, you’ll still owe $11999.
If you do the math out, by the time you pay back this loan, you’ll have paid *$11139.42 in interest* on top of the $12000.
**But this isn’t all the much money, what’s the big deal?**
Let’s take the numbers above and scale them up a whole lot.
Now you owe 8% APR on a 300k loan.
Same math as before to calculate your monthly APR.
8% of 300k divided by 12 months.
8% of 300k is 24k.
24k divided by 12 months is 2k.
You now owe 2k in interest every single month.
But your monthly payment is just $2200.
That means you’re only paying off $200 of your principle.
If we were to do all the math, the result would be that you will end up paying the bank **$493,940.96** of interest by the time you’ve paid off your loan.
That’s right. $493,940.96 *extra* dollars on an initial loan of just $300,000.
**Wow, that’s a big number! But 8% seems like such a small number!**
Let’s reduce the interest rate from 8% down to just 7%. A measly change of 1% interest can’t matter much, right? Wrong!
The same loan at 7% interest rate would cost you *$300,257.35.*
That’s right. For *one percent less interest* you save *over $150,000.*
The trick is that your APR *exponentially* increases the amount of time it will take you to pay off your loan. High APR means more of your monthly payment goes to interest and less to the principle.
This means that your principle will stay higher longer.
Because the principle is barely changing, the interest you pay every month is barely changing.
This isn’t a standard loan, loan payment, or APR. Most loans are for larger sums and might have a slightly lower APR, but require higher payments. This is just to give you a general idea of how this system works.
**And now we’ve finally reached why people refinance.**
Based on the previous example you should now understand, but I won’t leave you hanging.
People refinance because even reducing your APR by 1% can save you thousands (or hundreds of thousands) of dollars over the course of the entire loan.
Refinancing usually requires an initial investment of a few thousand dollars, but saves you much more than that over the length of the loan.
**Bonus Section: But I don’t want to give them all that extra money!**
Fear not, there are ways to shortcut the system. You can always make payments on your principle!
The more you reduce your principle, the less interest you owe every month.
So, even though your monthly payment stays the same, more of it goes to the principle and less to interest.
Pay your higher interest loans first!
Use the formula from the first step to calculate the APR of each loan you have.
Whichever loan has the highest dollar amount going to interest each month is the loan you should pay first.
Do the math! Don’t just pay off your biggest loan or your highest APR loan. Whichever loan has the highest dollar amount going towards interest is the loan that will cost you the most in the long run.
Latest Answers