If let’s say your interest rate is 6% but you want to refinance to 4% and it costs 2% to refinance, doesn’t that just make it the same number in the end? Google says the cost of refinancing is roughly 2-6% of the full loan. I don’t get how it makes it cheaper to refinance? Just seems like you’re paying the money upfront then. Please eli5! Feel like I’m missing something.
In: Economics
A 6% loan is 6% *per year*, you don’t just pay the interest once and then it goes away. You’re paying 6% interest on the principal balance for 30 years.
Paying 2% *one time* to reduce that to 4% interest for the next 20 years usually makes good financial sense.
A one-time 2% payment is *not* the same as 2% in interest for, say, a 30 year loan. If you pay 2% of $100,000, that’s $2,000. If you pay 2% in interest on $100,000 for 30 years, you’re paying a total of $3,952 over the length of the loan in interest (if you’re making the minimum payments each month).
Refinancing to a lower mortgage rate means having a lower monthly payment. That can mean having more money to save or spend on other things, and potentially making more money from renters if you decide to get a second property and rent your first one out.
Find a mortgage calculator and punch in the different rates. Then look at the amortization schedule. You’ll understand the difference then.
That 2-6% cost of refinancing is just a one time lump payment.
Your interest rate is every year. So the difference between a 4% and 6% interest rate is a 2% cost every year.
Just as an example, the total amount paid for a 6% $100k 30 year loan is $215k.
But a 4% is $171k
That’s a difference of $44k or 22 times more than 2% of the original loan amount.
The bank will tell you that if you can reduce the interest rate by a certain percentage then it is worth it to refinance. It is not to your advantage to refinance every time interest drops one quarter percent. I’m sure that formula changes over time depending on lots of other factors, that is why I always asked.
In addition to the interest factor, the other things to consider.
There are cash out redinances. In these instances, a homeowner can take advantage of any equity or appreciation that has built up since the original mortgage was taken out. Typically, this is done after many years of ownership, but can be done in other circumstances as well.
Lastly, in order to lower your monthly payment, you can stretch out a loan over a longer period of time than what you have remaining. So for example, if you are in year 15 of 30, you can refinance at 30 years at a new interest rate. What this does is take your remaining principal balance and stretch it out over an additional 15 years, essentially cutting your monthly payment in half. Yes, you will more to the bank in interest over the life of the loan, but some people are more concerned about their monthly budget.
So in summary three reasons why refinancing is a good idea:
The lower interest rate causes you to give less money to your bank over the life of the loan (and can lower your payment)
The equity in the house can provide cash in hand for emergencies or major renovations
The additional term, can significantly lower your monthly payment to help with budget issues.
The interest rate on a loan is PER YEAR, so a cost of 2-6% once means you’re paying the equivalent of a single year’s interest to reduce interest for balance of loan. It’s possible for interest over course of a 30 year mortgage to mean paying double the loan amount due to the interest.
But that 2-6% cost sounds super high… when I’ve refinanced in the past, the total fees were like $1000-1500 on $400k-ish loans. 2-6% is more like the closing costs associated with a new purchase, not a refinancing.
Lets say you take out a $300,000 mortgage at 6%. Your monthly payment would be about $2000/month. After 5 years you’ll have paid about $120,000 on your mortgage. You’ll have paid about $70,000 in interest and paid off $50,000 of your principal. This means you still owe $250,000. If you don’t refinance the TOTAL COST of your $300,000 mortgage will be about $500,000. You’ll pay back the $300,000 you borrowed, plus another $200,000 in interest. This means at the 5 year mark you’re still going to pay another $130,000 in interest.
But lets say you refinance at that 5 year mark. You pay 2% on your principal (the $250,000) and your rate drops to 4%. That means now, instead of owing $250,000 you now owe $255,000. But because your interest rate is lower, you’ll pay less in interest over the course of the loan. You’ll only pay $65,000 in interest on the the remainder of the loan. So some quick math, it costs you $5,000 to save ($130,000-$65,000) = $65,000.
You pay a little extra right now to save *a lot* over the long run.
In this situation if you refinance at the 5 year mark, you save $65,000 on the total amount you have to pay for your house. Instead of your $300,000 house costing $500,000, it costs $435,000.
To go along with others:
Does it make sense to refinance from X% to Y% APR? You have to do the math.
I bought a new house last year, with 5.75% APR for the first year, and then 6.75% going forward. I financed about $510k. I just did a VA Streamline refi down to 5.675%. I only had 1 year into the mortgage, so not much principal paid. In addition to the $10k refi costs, I had to pay VA Funding fee of ~$5k. So my new loan balance is ~$520.
But, the difference in payment will be ~$300/month. That means that it will take ~50 months (a little over 4 years) to make that difference worth it. If I was planning on selling (or was forced to sell) in < 50 months, or interest rates drop even lower in that time, then this refi will cost me money. If I stay here longer, then it was a good deal.
So, that’s what we used to balance the decision. Personally, I think 5% APR interest is here to stay, 3% was an abnormal situation. Time will tell if it was a good decision.
Latest Answers