– How does mortgage refinancing work, and why would a bank offer it if it saves the home buyer money?

Question

Why would a bank offer refinancing at a lower interest? Is any money saved at all, or is it just paid on a different timeline?

In: 265

Answer 1

If you have a 30-year loan (standard in the US) and refinance into a 30-year loan, the term of the loan also resets. Amortization has you paying mostly interest in the early years of the loan and mostly principal in the late years of the loan. So every time you reset the loan, you start over paying a lot more interest than you do principal. That’s how the bank makes its money.

Hypothetically, today, you get a mortgage for $350,000 at 6% interest. With your first payment, your principal is $348 and your interest portion is $1,750. You pay on the loan for 10 years, and your principal in September 2033 is down to $290,988.73. (At that point, your payment has evolved to $633 principal and $1,464 interest.)

At the end of 2033, you decide refinance your balance on the loan to 4%. At this point, you’ve paid $59,011 in principal and $199,095 in interest on the original loan. So you restart the clock on the loan to 0, and start making your payments again. At this point, your new payment is broken out with principal is $419/mo and interest is $969/mo. So, overall, the payment is a lot more affordable ($1,388/month for P/I vs $2,098 for the original loan), but you’ve maximized in the interest portion of your payments. (Here’s the fun bit, if you can, keep paying what you were originally paying ($2,098) by paying an additional $710 per payment, and you pay your 30 year loan off in 17 years instead of 30. You only end up paying $100,120 in interest payments over the life of the loan vs $209,132 if you just pay the base payment.

But, as with all things, there are caveats. In the US, your loan payment will also include money for property taxes and property/homeowners insurance. If your down payment was <20%, you’ll probably pay private mortgage insurance until your equity gets above the 20% line. And property taxes and insurance can go up each year, so the total payment amount will typically grow a bit from year to year.