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The mistake we make when we refinance

Borrower years into 30-year mortgages are taking out new 30-year loans, adding years of payments.

Jeff Brown
by Jeff Brown, MainStreet contributor

NEW YORK (MainStreet) — Thousands upon thousands of homeowners are trimming their mortgage payments by refinancing to today’s rock-bottom rates, but about a third of them are still missing out on the best possible deal.

That’s the finding of a survey by LendingTree that found that too many borrowers replace their old loans with ones that add years of payments.

“Only one-third of homeowners who have refinanced their existing mortgage in the last three years realized the benefits of a shorter-term home loan,” LendingTree said of its survey results.

In other words, a borrower five years into a 30-year mortgage takes out a new 30-year loan, adding five years of payments. Because the new loan typically carries a lower interest rate, the borrower’s monthly payment goes down. But some of that saving is offset by the extra years of payments.

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About 69 percent of homeowners who refinanced last year took out 30-year loans, meaning they took on years of extra payments.

To save the most, the new loan should have a term ending at the same time as the old one, or earlier. Taking out a 25-year loan instead of a 30-year loan does mean shouldering a slightly higher monthly payment. But the extra amount is principal, which pays down the debt. Because the debt on the loan with the shorter term gets smaller faster, the interest charges on the remaining balance get smaller faster. The snowballing effect can produce considerable savings in interest charges.

Imagine a homeowner who took out a 30-year loan for $300,000 at the average rate of 6.25 percent. Today, that borrower could get a new 30-year loan on the remaining $280,012 debt for only about 3.5 percent, cutting the payment to $1,257 from $1,847.

The alternative: take out a 25-year loan at 3.5 percent. The new payment would be slightly higher — $1,402 — but total interest costs over 25 years would be  $140,530 instead of $172,644.

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Why don’t more borrowers grab this extra saving? After all, even though the payment on a 25-year loan is higher than on the 30-year deal, it’s still far less than the borrower paid on the old loan, so it should be affordable.

Some borrowers probably figure they won’t keep the loan long enough to enjoy all these savings. Others undoubtedly focus on getting the lowest monthly payment they can.

LendingTree found that the typical borrower who refinanced reduced the interest payment by two percentage points, producing substantial savings. So for many the saving from refinancing is so big they don’t see the need to reach for a bit more that will take years to materialize.

Still, it’s worth running the numbers to see what you can save with a shorter loan term. Aside from reducing the number of years of payments, the shorter term often gets the borrower a lower rate as well. Fifteen-year loans, for instance, now average just under 3 percent, a half-point less than the 30-year deal.

 

For the past 20 of his nearly 40 years in journalism, Jeff Brown has written about personal finance, economics and the financial markets. He has been a staff writer at The Philadelphia Inquirer and other papers, and in his six-year freelance career has been a columnist for TheStreet.com and the Nightly Business Report on PBS and blogged for The New York Times, MSNBC.com and other Internet sites.