Refinancing when mortgage rates drop is usually an easy decision. A reduction in payment and the advantages of paying less interest can make great sense. What happens when rates increase? Does it ever make sense to refinance when rates are up? The answer is “maybe.”
Let’s take a look at how amortization can be used to win when rates are up.
In addition to the interest rate and loan amount, the loan term impacts your monthly mortgage payment. Most mortgages are spread over 30 years or 360 months. In these cases, the loan is amortizing across 360 payments. The shorter the amortization time, the higher the payments will be when all else is held equal. This is because the same debt will need to be paid off in a shorter period of time.
For an extreme example, assume you pay $100,000 in 10 equal payments. Without any interest at all, you will pay $10,000 per payment. Whoa. When the payment schedule is set to 360 months, the amount drops to just $278. This, again, is without factoring in interest. The same loan amount spread over more months results in a lower payment.
Amortization can benefit you
When it comes to understanding how amortization can benefit you, an example speaks mountains of truth. Let’s examine the pros and cons by looking at the Smith family’s options. (Note: the Smith family is fictitious in this case).
The Smith’s purchased their home ten years ago. At the time, the home was valued at 300,000 and they put $60,000 down. As a result, they started with a $240,000 mortgage. Their mortgage broker was able to obtain a rate of 3.5% for a 30-year mortgage. Their monthly mortgage payment has been $1,078 for the last ten years. This amount does not include real estate taxes or homeowners insurance.
The Smith’s have been making regular payments without contributing extra on a monthly basis. As a result, the Smith’s have $185,000 remaining to pay in the next 20 years.
Increasing cash flow with a refinance
The Smith’s have decided it may be time to refinance. They wonder if reducing their monthly mortgage payment is possible.
They learn a new mortgage at 4.375% is available. The new mortgage doesn’t require the Smith’s to pay anything out of pocket but will increase their loan to $187,000 to cover some closing costs.
If the Smith’s obtain this new loan, they’ll reduce their mortgage payment to $933, saving about $145 each month. While the Smith’s are interested in freeing up $145 each month, they wonder what else they have to consider when increasing cash flow in this way.
Extending the loan term
In the example above, the Smiths have determined they can save nearly $150 each month if they were to refinance. They wonder if any issues exist with extending the loan term.
Each family’s timeline and needs are unique. As a result, there is not a single answer to this question. Let’s examine the Smith’s again to see what they come up with.
The Smith’s have lived in their home for ten years. Now, with children in 3rd and 4th grade, they realize they’ve got just 12 years left until they are “empty nesters.” At that time, they plan to move to a smaller home on the coast. In light of this family plan, the Smith’s elect to continue with the refinance transaction.
Regardless of being in their old loan or a new loan, extending the loan term is not a major concern. This is because they plan to sell their home prior to either mortgage being paid off in full. The Smith’s elect to save $150 each month today because that was the best choice for them.
For more on saving money on mortgages – take a look at this recent post.