Jessica and James are a young couple who live in St. Louis, Missouri. They purchased a home seven years ago for $575,000. They made a down payment of $120,000. They were approved for a 30-year mortgage with a 4.25% interest rate.
If the interest rates fall, they may want to refinance their home loan at a lower rate. However, they need to weigh the money they will save in interest against the 3% to 6% they will be charged in fees. Refinancing requires an appraisal, title search, and application fees, just like the original loan.
Jessica and James’s Loan Information
Purchase Price: $575,000
Down payment: $120,000
Loan Amount: $455,000
Current Home Value: $600,000
Original Equity: $120,000
Current Equity: $206,202
Equity Gained: $86,202
Interest Paid: $128,211
Jessica and James are currently paying interest at a rate of 4.25%. By the end of their 30-year mortgage, they will have paid $805,797.54 with a total interest payment of $350,797.54. Their loan will be paid off in October 2044.
If they refinance, they will refinance the outstanding part of the loan, which is $368,798.
Currently, 30-year mortgage interest rates are at 3.2%, 15 years are at 2.43%, and 10 years are at 2.38%.
| Current | Refinance 30 years at 3.2% | Refinance 15 years at 2.43% | Refinance 10 years at 2.38% | |
|---|---|---|---|---|
| Total Mortgage Paid | $805,797.54 | $574,174.49 plus $188,019 for the first 7 years= $762,193.49 | $440,454.82 plus $188,019 for the first 7 years= $626,473.82 | $414,788.05 plus $188,019 for the first 7 years= $602,807.05 |
| Total Interest | $350,797.54 | $206,202.00 plus $128,211= $334,413 | $71,656.82 plus $128,211= $199,867.82 | $45,990.05 plus $128,211 = $174,201.05 |
| Mortgage Pay Off Date | October 2044 | October 2051 | October 2036 | October 2031 |
| Monthly Payment | $2,238.33 | $1,594.93 | $2,446.97 | $3,456,57 |
Shorten the loan term
Jessica and James may be able to shorten their mortgage term if they have more disposable income than when they purchased the home. This means that their monthly payments will be higher, but they will pay less money out in interest.
In this example, their monthly payments increased from $2,238.33 to $3,456.57 if they refinanced for 10 years. Their loan will be paid off 13 years sooner. They will save approximately $174,596 in interest payments if they can afford the higher monthly payments.
According to Investopedia, refinancing is a good idea if you can reduce your interest rate by at least 2%, though some people will refinance if they can save 1%. If the couple does not shorten their loan term, the lower interest rate will decrease their monthly payments.
The couple will need to consider how long they intend to stay in their current home to determine whether they will be able to recoup the money paid as fees with the savings from their lower interest rates.
Modify the terms
An adjustable-rate mortgage (ARM) has a variable interest rate, whereas a fixed-rate mortgage (FRM) does not. As a result, ARM rates are typically lower than fixed-rate mortgage rates. However, if the ARM rate rises above the fixed-rate mortgage, converting to a fixed-rate mortgage can lower your interest rate while also stabilizing your monthly payments.
Gain access to equity
Homeowners may refinance their loans to gain access to the equity. They may use this money to finance home improvement projects or to consolidate their high-interest credit card loans. This strategy may be a great choice if it does not lead to more credit card debt.
Suppose Jessica and James needed money to pay for an addition to their home. The addition will cost $40,000. Instead of borrowing $368,798, they borrow $408,798 for 30 years at 3.2%.
Their monthly payment would now be $1,767.92 instead of the $1,594.93 that they would have paid with the original 30-year refinance in which they only borrowed the outstanding loan amount. Over the 30-year loan period, they will pay an extra $32,551 for the $40,000.
Borrowing against equity can become a slippery slope as the loan is extended, equity is not increasing, and more and more interest is paid over the life of the loan.
Final Thoughts
Suppose Jessica and James can reduce their interest payments over the loan period by shortening it. They will build equity more quickly and save money they can invest elsewhere.
When deciding whether to refinance, you must consider how much you can afford to pay in monthly mortgage payments, how long you intend to stay in your home, and how you intend to use the money you save. When answering these questions, a wealth advisor can assist you in providing clarity.
