In part 1 of this blog, “Refinancing Your Home Mortgage and Why You Should Do It Now!”, we mentioned that with today’s very low interest rates, around 4%, almost everyone with a higher rate mortgage will save money by refinancing. We also noted that not only would you save money but you will build equity in their home faster and pay less interest to the bank! Depending on your situation, you will be able to increase or decrease the term of you mortgage, consolidate higher interest debts, and it could give you the opportunity to get out of or into an Adjustable Rate Mortgage (ARM). There are also reasons NOT to refinance. For an overview of those reasons read more about them in part 1.
Keep your eyes open at the end of this blog because you will be able to access “A Guide to Mortgage Refinancing” which is a printable PDF published by the Federal Reserve for consumer protection. In addition, we strongly advise visiting your accountant or financial advisor for an evaluation of your personal situation.
Now we can get into the meat and potatoes of part 2 of this series. In part 1, we promised real life examples and now we can deliver.
We have prepared several examples of the benefits of refinancing with a detailed explanation of the factors that affect these benefits along with alternative scenarios that you might want to use.
Example #1 - $200,000 Home Mortgage Refinance
These first examples take a $200,000 30-year Fixed Rate Mortgage at two hypothetical interest rates and see the savings after refinancing to a 4% interest rate.
What we first notice is that there is a dramatic drop in the monthly P & I payment, You will reduce your monthly payment by refinancing and obviously the savings is larger when the difference between the Current Rate and the New Rate is greater. The savings is substantial ($309.31/month or $3711.72/ year for just a 2% decreased rate and $375.77/month or $4509.24/year for a 3% decreased rate).
Second, we see that paying a lower rate of interest with each payment will earn more equity. This is because your lower interest rate will result in more of each payment actually going toward your principal payoff.
In seven years you will have saved $8,713.55 refinancing down from a 6.5% interest rate or $10,175 refinancing from a 7.5% interest rate. We use 7 years because this is historically the approximate amount of time that over half of home owners will live in a home before moving.
If we combine the drop in monthly P & I payment and the increase in equity and then assume the homeowner does sell in 7 years, the result in gain will be:
(6.5% original Mortgage) $3,711.72 X 7yrs. + $8,713.55 for a total gain of $34,695.59
(7.5% original Mortgage) $4509.24X 7yrs. + $10,175 for a total gain of $41,739.68
So what happens if you stay in the home for the life of the mortgage? There are actually two scenarios that apply in this case.
In the first scenario, you take the smaller payment will result in the savings of $111,739.01 (from the 6.5% mortgage) or $135,277.20 (7.5%) almost all of which is accounted for by the decreased interest paid to the bank.
The second scenario is if you continue paying the old payment even though you could be paying a significantly lower payment. Doing this will lead to paying off the loan much earlier, around 17 years instead of 30 for both interest rates, and making you payment free 13 years earlier. During this time you could invest those funds to accumulate substantial wealth.
Example #2
(click to enlarge)
In this next example we use a 6.5% Mortgage being refinanced to a 4% Mortgage but this time we look at the effect when we vary the amount being financed.
The most important benefit still applies. You will reduce your monthly payment. Notice that the amount that you save increases as the principal amount of the mortgage increases. A $150,000 mortgage saves $231.98/month while a $300,000 mortgage saves a staggering $665.40/month.
All of the other factors in the previous discussion about the benefits of refinancing from a higher interest rate to a lower rate still apply. Note that the decreased payment and increased equity is proportional to the amount being financed.
Everything changes when we combine the facts in Example #1 with the facts in Example #2.
The last column is looking at the same $300,000 Mortgage at 4% Interest reduced from a 7.5% and things are different.
The benefits are no longer proportional to either the amount being financed or the benefits of a decreased interest rate the combination of these factors now is greater than each alone. (See the last two columns in the chart above.)
The $300,000 - 7.5% Mortgage has its payment reduced almost three times as much as the $150,000 6.5% Mortgage. The equity gained in 7 years on the 7.5% Mortgage is 2.6 times as great as the $150,000 6.5% Mortgage.
If the homeowner does sell this home in 7-years, this refinance 7.5% Mortgage to 4% will result in a gain of $665/month reduction of payments X84 months plus 17,324 in Equity = 73,184. Refinancing the 6.5% Mortgage results in a total gain of $52,072.12
The overall conclusion of these refinancing scenarios are that we have proven what we stated at the beginning:
- Refinancing to reduce the Interest Rate of your Mortgage will reduce your monthly payment.
- You will increase the equity you accrue by decreasing Interest payments and increasing Principal reduction every month.
- Over the life of the Mortgage you will decrease the amount of interest you have paid to the bank.
- The two factors which determine these benefits of refinancing are the difference between the Interest Rate of your current Mortgage vs. the new Refinanced Interest Rate and the amount of principal being refinanced.
- Finally, the combination of the greater the difference in interest rates and the more principal being refinanced results in the most savings.
BUT, you must remember Refinancing is in fact getting a whole new Mortgage, and that process has time and money costs. You need to determine the relative costs and benefits as they apply to your situation. The best advice is to contact your accountant and/ or your financial consultant.
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