Three Rules of Thumb for

Mortgage Refinancing

 by:

Stephen L. Nelson, CPA

You might think that deciding to refinance a mortgage requires only a

quick comparison of loan interest rates. Unfortunately, that's not really

true. Refinancing is trickier than that! Fortunately, three useful rules

of thumb can often help you make sense of refinancing opportunities.

Rule 1: Don't Ignore Total Interest Costs

You really want to use refinancing as a way to reduce the total

interest cost you pay. While that sounds simple in principle, it is

sometimes difficult to do. The interest costs you pay are a function of

the interest rate, the loan balance, and the loan term period.

When people refinance, they tend to focus solely on the loan interest

rate. But they often don't pay as much attention to the loan term or the

loan balance.

When you use refinancing-even refinancing at a lower interest rate-to

increase your borrowing or to extend the time over which you borrow, you

often aren't saving money.

Rule 2: Trade Expensive Money for Cheap Money

For refinancing to make economic sense, however, you do need to swap

higher interest rate debt for lower interest rate debt. This calculation,

however, is tricky. To make an apples-to-apples comparison, you must look

at the annual percentage rate that will be charged on your new loan-this

is the best measure of the new loan's interest rate cost-and then compare

this to the loan interest rate on your old loan.

You don't want to compare interest rates on the two loans nor do you

want to compare annual percentage rates on the two loans. Again, just to

make this perfectly clear: You want to compare the loan interest rate on

the old loan to the annual percentage rate on the new loan.

When the annual percentage rate on the new loan is lower than the loan

interest rate on the old loan, then you are truly paying a lower interest

rate.

Comparing annual percentage rates with loan interest rates seems

confusing at first. But note that you would pay only interest on your old

or current loan, so that's all you need to look at in terms of its costs.

With a new loan, however, you would pay both interest and any origination

or closing cost fees. The annual percentage rate wraps the interest rate

charges and setup charges, origination charges, and closing cost fees into

one interest rate-like number.

Rule 3: Don't Lengthen the Repayment Period

Be careful that you don't extend the length of time you borrow by

continually refinancing. For example, one common rule of thumb states that

every time interest rates drop by two percentage points, you should

refinance your mortgage. However, there have been times in recent history

when following this rule would have had you refinancing your mortgage

every few years. This could mean that you would never get your mortgage

paid off. If you refinanced every few years, you would suddenly find

yourself still 30 years away from having your mortgage paid.