Refinancing your mortgage to get a lower interest rate is a good thing, so long as the amount you will save on interest payments is greater than the closing costs of doing the refinance. But so many times, I hear people say that they don’t want to refinance their mortgage, because the beginning of a mortgage always involves high interest payments and low principal payments, and they don’t want to start over and pay more interest on their monthly mortgage payments.
This is where I start banging my head on my desk. It’s a common refinancing myth, that a refi means you start over and pay more interest up front, instead of paying down the same amount of principal you were paying before. But the truth is that you can control how much of your payment goes to principal, and if you keep paying the same monthly payment as before, you’re going to be paying MORE principal than you were before. But rather than tell you, I’ll show you.
The Foundation of the Myth
When you first get a mortgage, your loan balance is at the highest it will ever be. (Unless you have a reverse or negative-amortizing mortgage, but let’s not go there right now.) By the time you make your last mortgage payment, your loan balance is the lowest it will ever be. Because your loan balance is the highest in the beginning, you will pay more interest in the beginning. Because your loan balance is the smallest at the end, you pay the least amount of interest at the end.
Your monthly payments, however, stay the same for the entire life of the loan. The only way that is possible is if the early payments, when the interest is the highest it will ever be, make up most of the monthly payment. Over time, the principal gets paid down slowly, and the interest gets smaller and smaller, until the end of your loan, when you’re paying mostly principal and just a little bit of interest.
But just because you’ve gotten to the point where you’re paying more principal than interest, that doesn’t mean that a refi will wipe out all the progress you’ve made to date. You can pick up right where you left off. You have more control than you think over your loan.
Your Current Mortgage
Let’s say your current mortgage is a 30-year fixed at 4%. The initial mortgage balance was $250,000, but that was 9 years ago, on February 1, 2007, when you first bought the property. You’ve paid down some principal since then. This is what your amortization schedule looks like (click to enlarge):
(Quick side note: I ran this amortization schedule in about one minute using a Microsoft template in Excel. If you want to create your own amortization schedule, you can create one from scratch by following these instructions, or go the easier route and download a template like I did. You can do that by going into Excel and click “File” and then “New”, and enter “amortization” in the search box to find a template. One of the first options will be a template that looks like the image above. There are a few other options, too, but this one is the most helpful, in my opinion.)
According to our handy amortization schedule, we can see that your monthly payments are $1,193.54. When your loan first started out, your monthly payment was divided into $360.20 in principal, and $833.33 in interest. (Note: that part of the schedule is not visible in the above image. I had to scroll up on the amortization schedule itself to view it.) As of your February 1, 2016 payment, the principal portion of your payment has increased to $514.27, with the remaining $679.27 going to interest.
This is what we would expect, right? Over the past 9 years, you’ve paid your principal down from $250,000 to about $203,780, so your interest costs have dropped, and your principal payments are increasing.
So what happens if you refinance? Let’s look and see.
Refi for a 30 year mortgage at 3.5%
Say the bank is offering a new 30-year mortgage at 3.5% interest. You plan to refinance exactly the amount of principal owed on your existing loan (i.e., you’re not pulling any cash out). Your current loan balance is $203,780.75, and you plug that and your new interest rate into the loan amortization table. Here’s what it looks like (click to enlarge):
But wait! You notice that your mortgage payment is smaller, but you’re not paying off as much principal as before, right? That’s correct, because your new loan term is for another 30 years, instead of being paid off over the remaining 21 years of your original loan term. By stretching out the loan term for a longer period, you’re reducing your principal and increasing your interest payments, because you’re borrowing the money for a whole 9 years longer than you were before.
This is why the refinancing myth exists: if you refinance and accept your new loan schedule as-is, and the loan term of the new loan means you’re extending the loan payoff date past what the original payoff date was, then you are starting over and paying more interest up front.
But you’re smarter than that, so you know better than to just take your new loan payment schedule and go with it. Here’s where you shatter the myth and write your own future.
Shatter the Myth and Take Matters Into Your Own Hands
There are a couple of ways to make sure you’re not starting over on your loan. The first is to pay a little extra each month to make sure you pay off your loan by the end date of your original loan term (the “conservative approach“). The second is to continue to make the same monthly payment you were before, which will now pay off your loan earlier (the “moderate approach“).
The Conservative Approach
If we apply the conservative approach, we just need to go back to that handy amortization schedule and add an extra payment amount until the loan schedule shows the loan as being paid off by the original loan payoff date. In this case, I toyed around with the numbers and found that adding an extra $228 in monthly payments ended up with a payoff date of 2/1/2037, 30 years from the date of the original loan. Here’s what it looks like:
You’ll notice that by doing this, your loan payment is still lower than it was before ($1,143.07 versus $1,193.54), so you’re still saving about $50 per month over your prior loan payment. But your principal payment from the get-go is $548.71 per month, which is an increase over the $514.27 that you would have paid on your original loan. You’re making more progress than before, not less, and you’re still saving money every month.
The Moderate Approach
If you want to be just a little more aggressive about your loan payoff, you can use the moderate approach instead. This approach involves keeping your monthly mortgage payments the same as they were before. Here’s what that would look like:
Now you’re starting off by paying a principal payment of $599.18 in your first month, which is quite a bit better than your original $514.27 that you would be paying in February 2016 under your original loan. But the best part about this moderate approach is that your loan will now be paid off in November of 2035, which is 15 months earlier than your original loan payoff date. Over those 15 months, you’ll be saving about $17,900 in payments!
As compared to the conservative approach, by paying the extra $50 per month to maintain your same old loan payment amount of $1,193.54, you’re saving $5,635.44 in interest savings over the life of the loan. You’re already used to making that same mortgage payment, so it shouldn’t cause you any pain to continue that payment amount.
(If you want to get even more aggressive about your loan payoff, you can follow the aggressive approach described here.)
Myth Busted: A Refi Does Not Mean You Start Over and Pay More Interest
There is nothing magical about loan amortization (except that adding just a little extra principal payment each month can give you an insane amount of positive financial momentum by compounding your interest savings). A refi can give you the benefit of a lower interest rate, and you can effectively pick up where you left off on your earlier loan by simply adjusting the amount you pay each month to make sure you stay on track, or use the interest savings to speed up your loan payoff. There’s no such thing as having to start over and pay more interest simply because you refinanced your existing loan.