Thinking about mortgage refinancing? Think shorter not longer!

Thinking about mortgage refinancing? Think shorter, not longer.

Finance is about making the best choice for what to do with your money. “ Is there a better opportunity if I did something else with my money?” is the question you must ask yourself before making a major financial decision.
There will always be spending decisions you must make, or cannot avoid, when you can’t factor in an alternative for the money. Food, medicine, clothing, transportation, even insurance are among those financial commitments. But notice I did not mention housing.
Of course we all have to live someplace, and that place costs money. You can buy or you can rent. There is a financial analysis you can do to determine which way is more financially advantageous.
But if you own a home with a mortgage and you’re considering refinancing that mortgage are you mostly being driven by the difference in the monthly payments? Sure it affects the household budget and if you need the savings in the mortgage payment to help pay for other necessities, then it’s an easy decision.
However, if all you’re looking to do is take advantage of lower rates, than deciding to do this just on the basis of lower monthly payments may not be the best way to evaluate the refinancing decision. It’s the term that matters more, not the difference in interest rates. Always think shorter, even if the difference in rates or monthly payments is not that great.
Let’s do a little analysis:

If you currently carry a 30 year mortgage and are 5 years into it ( you paid 60 months) refinancing to another 30 years mortgage at a lower rate will save money; however, it’s not an optimal financial decision.

Here’s why. By staying with the existing mortgage, it’s fully paid in 25 years. At that time you can redirect the monthly payment into an investment program. By refinancing to a new 30 year mortgage, you give up this opportunity, plus you have an extra five years to pay with the new mortgage, an added real cost. The benefits of the lower monthly payments are severely limited by those two costs. You are paying for the last 5 years twice; or, think of it as a 35 year mortgage.

Instead, refinance into a shorter term mortgage, say 20 years. Even if the monthly savings are not as great, the true benefit comes from reducing the back end of the mortgage. Here’s why. You move up the time when reinvestment of the mortgage payments begin – to the end of 20years instead of 25 years; plus you don’t incur the opportunity cost by keeping the old mortgage that has a 5 year longer term. These two benefits far outweigh the benefit (or cost) from the difference in monthly payments.

Illustration:
Assumptions: Original mortgage: 30 year, fixed 6.50%, $300,000, $1,896.20/month
Current balance: $280,833
New 30 year mortgage: 5.25% fixed, $280,833, $1,550.70/month; save $345.45/month
20 year mortgage: 5.10% fixed, $280,833, $1,868.92/month; save $27.28/month
7% reinvestment rate, closing costs $10,000

New 30 Year Mortgage
Present value of monthly savings: $48,891.47
Present value of 5 year reinvestment term current mortgage: -16,743.98
Present value of extra 5 years new 30 year mortgage: -13,693.73
Closing costs: -10,000.00
Net Benefit $ 8,453.76

New 20 Year Mortgage
Present value of monthly savings: $ 3,519.73
Present value of 5 year reinvestment term current mortgage: +23,731.96
Present value of extra 5 years new 30 year mortgage: +23,390.54 Closing costs: -10,000.00
Net Benefit $40,642.24

Yes, there is a temptation to go with the much lower monthly payments of a new 30 year mortgage. However, the monthly payment on a 20 year mortgage is virtually the same as what you’re paying now. Since, you have adjusted your lifestyle to the larger payment of the original mortgage why not roll that into a new 20 year mortgage. A superior financial decision compared to a new 30 year mortgage. You will be mortgage free sooner and more importantly have money to invest sooner, while monthly costs are almost the same.