Dear Dr. Don,
Ten years ago, I took out a 15-year mortgage for $140,000 at 5 percent. I can get a much better rate now, but would it be worth refinancing? According to amortization tables, I have paid off most of the interest and I am now paying mostly principal. If I refinance now, won't I just be paying interest costs again?
-- Dan Doublecount
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I picked your question because it brings up a common misconception in mortgage financing. Each month, the borrower pays the monthly interest expense on the outstanding loan balance. If you have a current loan balance of $50,000, you've been paying monthly interest expense on that $50,000 since you closed on the loan 10 years ago. What reduces monthly interest expense is principal repayments. They are part of your monthly mortgage payment.
Yes, more of your monthly payment is principal repayment versus interest expense than a decade ago. But that's because of past principal repayments. With five years left on a 15-year mortgage, if you refinance into a new 15-year mortgage, then you pay additional interest expense by extending the loan term. You would be taking 25 years to pay off the existing mortgage balance instead of 15.
If you refinance the remaining five years, with a new five-year obligation at a lower interest rate, you reduce your total interest expense. Presuming good credit and adequate equity in the home, it's not hard finding a lender that can offer you a lower interest rate mortgage. What's hard is finding a lender to loan you five-year mortgage money.
Not to worry, as long as there's no prepayment penalty, you can make additional principal payments on the refinancing to pay off the loan in five years. You will keep your original payoff date and save money on the interest expense.
Will you save enough to make refinancing worthwhile? The higher the closing costs on the refinancing, the harder it is to justify refinancing when you're already so close to the finish line. Bankrate's refinance interest savings calculator can show you the interest savings. The calculator doesn't consider the loss of any mortgage interest deduction, but at this stage in the game it's not likely to be a deciding factor in the refinancing decision.