Low mortgage interest rates stimulate homeowners to refinance

The usual reasons to refinance a home mortgage loan are to reduce the monthly payment or to raise cash. The third option, which is underappreciated, is to shorten the period of indebtedness.

The third option is seldom used. Therefore, many homeowners are refinancing for the wrong reason.

Indeed, borrowers who refinance into a new mortgage that has the same term as the original term of the existing mortgage - a new 30-year supplanting an old 30-year, for example - extend the life of their mortgage instead of shortening it. That is not the way to go for anyone who expects to retire someday.

A major reason few borrowers refinance in order to shorten their period of indebtedness is that the benefits are delayed and seldom displayed. Where the first two options provide immediate feedback in lower payments or cash-in-hand, benefits of the third option are deferred for years.

Indeed, unless the decline in mortgage rates has been unusually large, the immediate impact will be a higher monthly payment and/or upfront refinance costs to be paid. The long-run benefits are nowhere calculated.

There are two such long-run benefits.

The major benefit, in addition to the psychic satisfaction of being out of debt, is enlarged future borrowing power if it is needed. As an example, if they need additional funds when they hit 62 and look to a HECM reverse mortgage to get it, every dollar of debt remaining on their existing mortgage reduces the amount they will be able to draw on the reverse mortgage dollar for dollar.

The second benefit, which arises from the decline in market interest rates, is the reduction in cost. The cost of a new refinanced mortgage carrying a shorter term will be lower than the costs of retaining the current mortgage. Here is an example:

Prudence took a 30-year fixed-rate mortgage of $320,000 at 4.5% just five years ago. That gives her 25 years to go, which she would like to cut to 20 years, or even 15 years if that is possible.

On June 7, she could have refinanced into a 20-year mortgage at 3.125% with $5,700 of upfront costs. Her new payment at $1,636 would be just slightly higher than the existing payment of $1,621. But her total costs over the next 20 years would be $398,000 compared to $486,000 if she retains her current mortgage.

In addition to being out of debt five years sooner, she will save $88,000 during the 20-year period.

Our mortgage system allows borrowers to select from a menu of interest rates and upfront charges called "points." This allows borrowers with extra cash to reduce the monthly payment, or the reverse. If Prudence does not have the $5,700 upfront charge, for example, she could largely eliminate it by accepting a rate of 4.125% and accepting a higher monthly payment. Her savings in that case are reduced to $55,000, but it is still a good deal.

Applying the same approach to a 10-year debt reduction, the cost to Prudence would be higher but the cost savings would be correspondingly greater. At the posted rate of 2.75% on a 15-year mortgage, she would be obliged to increase her monthly payment by $166 and pay additional upfront costs of $10,275, but she would save $120,000 over the 15 years relative to her current mortgage.

The major benefit, of course, is that she would be out of debt 10 years earlier.

Differences in total cost over many years is not the ideal way to measure refinance options. As the sum of monthly payments plus upfront charges, it undervalues those charges. An alternative is to take the present value of total costs, which I have done. This reduces the refinance cost savings - it drops from $120,000 to $45,000 in the example above - but the conclusions are not affected.

• Contact Jack Guttentag via his website at

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