by Christy Bieber | Feb. 20, 2021
Thinking of refinancing your mortgage? The amount of time you spend paying back the loan will determine how refinancing affects your finances.
If you're thinking about refinancing your mortgage, you'll need to make lots of choices, including what mortgage lender to borrow with and whether to lock in your rate or not. You'll have another choice to make as well: what your new loan term should be.
The most popular options for mortgage refinancing are 30-year, 20-year, or 15-year loans, although there are some lenders that offer other alternatives as well. And the decision on which of these loan options is right for you could be the biggest determining factor in whether refinancing saves you money or not.
Most people focus on interest rates when refinancing a mortgage and with good reason. After all, a lower interest rate means you pay a smaller cost to borrow, which should reduce your total borrowing cost.
But the rate you pay to borrow isn't the only factor that determines how much you'll pay your lender over time. The length of time you pay interest is also a major determining factor in total borrowing expenses. In fact, there are some circumstances where you could qualify for a new mortgage at a lower rate and still end up paying more over time because you stretch out your repayment timeline too much.
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Unfortunately, while it probably makes intuitive sense that paying interest for a longer period of time makes your loan cost more, many people don't take this into account when choosing a mortgage refinance loan. And there are a few reasons for that.
Lenders often push you to focus on monthly payment, rather than looking at the big picture. And if you can drop your monthly payment by a few hundred dollars, that may seem really attractive -- so much so that you're willing to overlook the fact that you'll be increasing total borrowing costs by a lot if you extend your repayment timeline substantially.
Unfortunately, most people who choose 30-year refinance loans already have 30-year mortgages. These loans with the longer timeline are so much more common, mostly because they come with payments that are so much lower. But if you refinance to a new 30-year loan and you've been paying on your current home for any length of time at all, you'll inevitably be extending your payoff time.
Ideally, when you refinance, you can choose a loan repayment timeline that has the same payoff period as your current loan. If you have 20 years left to pay on your current mortgage and you opt for a 20-year refinance loan at a lower rate, you'll both reduce your monthly payment and lower total borrowing costs.
If that isn't possible, choose a loan with a shorter payoff timeline if maximizing your interest savings is your primary goal. Chances are good a refinance rate with a shorter repayment term will also come with a lower interest rate than a 30-year refinance loan. That means you'll save money both by borrowing at a lower cost and by making payments for less time. The tradeoff, though, is that your monthly payments may not go down much even if you drop your rate substantially. And it's possible they might actually go up.
Another option may be to choose a loan with a longer payoff timeline but pay a little extra towards it each month. That way, you could benefit by dropping your rate and payments. You might even avoid making your payoff time much longer -- despite the longer term -- since your extra payments will reduce your balance more quickly and allow you to pay off your loan ahead of schedule.
Your final choice is to simply take the loan with the longer payment timeline and pay as required. This approach isn't necessarily bad if you make wise use of any extra money by investing it. In fact, since mortgage refinance rates are so low right now, you could actually end up better off this way since the return on investment you can likely earn by investing will be well above the interest rate on your new loan. But just be aware that your loan will cost you more money this way, and be sure that making the choice to refinance really is the right move.
Chances are, interest rates won't stay put at multi-decade lows for much longer. That's why taking action today is crucial, whether you're wanting to refinance and cut your mortgage payment or you're ready to pull the trigger on a new home purchase.
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