There's More to Refinancing Than Just Lowering Your Interest Rate

With mortgage interest rates near a 50-year low, homeowners are very interested in refinancing.

But too many are focused on the wrong thing: Getting the lowest mortgage interest rate they can.

I'm not against lowering the interest rate on your loan. But being smart about refinancing means being savvy not only about what interest rate is attached to the loan but also on how much you'll save each month and over the duration of the loan.

And that point seems lost in the headlines.

I took a call on my radio talk show from someone who was offered a deal to lower his mortgage interest rate by 1 percentage point. But the loan is only for $120,000 and he was going to be charged $8,500 in closing costs and fees. How much will he save each month? About $200. It will take him more than three years to pay off the costs of the refinance.

And there's another wrinkle: He's already six years or so into his 30-year fixed-rate mortgage. If he refinances for another 30-year loan, he'll repay nearly the same six years of interest all over again.

Even if my radio show listener plans on staying for another 10 years in the home, his nearly $2,400 per year of "savings" will be more than eaten up by repaying the six years of interest on the loan.

How do you make this work out? You have to not only cut the interest rate on your mortgage, you have to shorten the term length as well to at least match the end date on your current loan. That way, you can compare loans on an apples-to-apples basis.

In the case of my caller, if he can refinance into a 15-year mortgage, he'll shave nine years of payments off of his loan. Also, he'll pay less overall interest, because the interest rate on a 15-year fixed-rate loan is less than the interest rate on a 30- or 40-year loan.

The total monthly payment might be the same, or slightly more, but the savings over the long term will be far greater than if he refinances into a 30-year mortgage just to save $200 per month. This way, he'll be making the $8,500 in closing costs and fees he has to spend go further.

But there's another option that should be considered. What if you take the amount you'd pay in loan fees and use it to prepay your mortgage?

Prepaying your 30-year mortgage can save you tens of thousands of dollars over the life of the loan. Why? You only get charged interest on the amount you borrow. So, if you prepay the balance due, you'll save yourself the interest charges on that money. It really adds up over the years.