Mortgage refinance myths, busted!

Obtaining credit can be a tedious and time-consuming process. Lack of factual information may lead you to develop myths about the subject. And these myths could ultimately prevent you from making decisions based on inaccurate considerations. Here, we dispel some of the most wide-spread misbeliefs about mortgage refinancing so that you can separate wrong from right.

• Lower interest rates always translate to huge savings
• Refinancing means an increase in loan term
• Your current lender is your best option

Let’s dive deeper into each of these to understand why these are the biggest myths about mortgage refinance.

1. Lower interest rates are desirable, but lenders know what they are doing.

When it comes to mortgages, a basic rule of thumb is that one should look for the lowest possible rate of interest. This rule is correct in principle, but we should be aware that interest rate is not the only factor at play.

The term of loan is a huge factor in determining if the lower rate of interest will translate to the savings you are looking for. Additionally, for refinance, there is a variety of associated fees such as application fee, appraisal fee, closing fee etc. These can sometimes add up to a few thousand dollars eating directly into your potential savings.

Let’s walk through a simple example to help us understand the mechanics. Assuming that you are five years into your 30-yr mortgage. Original loan amount of $300,000 was financed at 4.75% per annum. Your current monthly payment stands at $1,565. Now, your lender calls to inform that you are eligible for a mortgage refinance at a new lower rate of 4.25% for a 30-yr term. Before you say, “That’s great! Let’s sign the paperwork.”, let me walk you through the numbers here.

Figure 1

If you choose the above option to refinance:

1. You’ll pay a lower rate of interest for the next 30yrs.
2. The mortgage will last 5yrs longer.
3. Your monthly payment would decrease from $1,565 to $1,350. So, more money in your pocket today.
4. The total amount you to pay-off the whole thing increases by $16,643. So, less money in your pocket in the longer term.

You’ll end up paying $16,643 more than what you would have in case you had not refinanced. This calculation doesn’t yet account for a range of fees that the lender would charge to process the refinancing. Assuming a lump sum amount of $3,500 for fees, you’ll paying ~$20,000 more in the long-term. Doesn’t look great now, does it?

This is not to say that there is no value in mortgage refinancing. If someone is unable to make ends meet today due to restricted income and needs to lower their monthly payments, this could actually be a very useful option. But it’s important to understand that there is a trade-off in the long-term. After all, the lender is in the business of making money too.

2. Increased loan-term is not the norm

Most refinance options that we see lead to an increase in the loan period which, as explained in the example before, leads to more profits for lenders. But this doesn’t mean there aren’t any exceptions to this. Often times, it can be mutually beneficial for the lender and the borrower to leave the loan-term unchanged or even reduce it. This is less common when working with the same lender but for borrowers willing to switch lenders, there may be some lucrative options out there. When lenders are looking to increase their loan portfolio due to a change in risk environment they go after borrowers who are currently with other lenders. In such cases, the fees associated with refinance is a big money-making opportunity, in addition to earning interest income over the term of the refinanced mortgage.

Recycling the example used above, here is what a shorter-term refinancing would look like.

Figure 2

In this case, you get a reduced loan term with the same rate of interest. Assuming $3500 for processing fees, choosing this option would save you approximately $23K in the long term. On the other hand, the new lender earns interest income for the next 22yrs as well as the fees.

Continuing the logic from above, if you find a refinancing option with reduced loan term and reduced interest rate, you could have even greater savings. Here is an illustration of such a scenario:

Figure 3

A number of factors can impact your potential to grab such opportunities. Credit scores, payment history, income levels, change in interest rate environment and mathematical skills could all make a difference here.

3. A good history with a lender helps, but weigh your options objectively

Loyalty plays a big role in the banking industry and for good reason. We all have a friend, relative or acquaintance who likes to work with particular banking institution or lender and it’s not a coincidence. When it comes to lending, banks/lenders are usually able to offer great deals to customers who have a strong history with them. This is majorly due to the fact that they are better able to assess the financial behavior of a customer who has been with them for a long time.

Moreover, it can be challenging to switch your banking institution entirely or even add another one to your list simply because it means a ton of paperwork and the headache to keep track of one more thing. But this does not mean that shopping for better rates is an effort in vain. In fact, this is a great way to keep yourself abreast of all the options that become available in the market. Institutions are constantly competing for our business and that’s how it should be. Refinancing is a decision that will impact your finances for many years to come and proper research and diligence is the only way to move forward. Various private and state-owned lending institutions as well as local credit unions are constantly coming up with new offers to attract borrowers and it is prudent to take advantage of these.

If you recently had a mortgage or refinance related myth busted, please share with us via the comments section so that other users can benefit from it.

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