Refinance to shorter term, shave interest

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Dear Dr. Don,
Should I refinance from 5 percent to 4.5 percent? The monthly payment will be about the same as it is now, but I’d go from a 30-year to a 25-year mortgage. Closing costs should come in at about $5,000. What should I do?
— Michael Mired

Dear Michael,
The old rule of thumb was that you wanted to capture at least a 2 percent difference in interest rates before looking to refinance. That’s no longer the case. You just want to be able to capture enough interest savings net of closing costs for the refinancing to make sense over the time you plan to stay in the house and the loan.

Serial refinancing is an issue. If you refinance every time you can capture a 0.5 percent in savings, you’ll do a series of refinances when you would have been better off doing one. Those closing costs add up. That said, we’re at near-record lows in mortgage interest rates so there won’t be many, if any, opportunities to refinance at lower rates.

The maturity matters. You’re striking a balance between what you can afford for a monthly payment and the total interest expense. The table below shows how shortening the mortgage term to 15 years can save you tens of thousands in interest expense. But that only works if you can afford that higher payment. If you can’t afford the higher payment, it makes sense to refinance with a longer term and plan to make additional principal payments when your budget allows.

4 refinancing options
Loan amount $200,000 $200,000 $200,000 $200,000
Loan term (years): 30 25 20 15
Interest rate: 5.00% 4.50% 4.00% 3.61%
Mortgage payment: $1,073.64 $1,111.66 $1,211.96 $1,440.59
Total payments: $386,511.57 $333,499.49 $290,870.56 $259,306.77
Total interest expense: $186,511.57 $133,499.49 $90,870.56 $59,306.77

Bankrate’s refinancing calculators will let you crunch the numbers on your loan. Just remember that to capture all the interest savings you have to stay in the house and the loan.

For refinancing to be viable from a cost perspective, you have to capture a level of interest savings greater than the costs of refinancing. This is a better standard than the break-even rule that simply divides the monthly payment savings into the closing costs to see how long it takes to “recoup” your closing costs. That’s because the payment reduction doesn’t measure the interest savings.

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