Most advisers offer this advice to homeowners refinancing their mortgages: Match the term on the new loan to the years left on the old one. But in a crisis, the homeowner can opt to do the opposite, cutting the payment as much as possible and freeing up cash to stave off disaster.
Once the emergency has passed, you can step up your mortgage principal payments to reduce the extra interest costs incurred when you extend the loan term.
In the case of an ordinary refinancing, the traditional advice is sound. Imagine if you were five years into a 30-year loan charging 6%, the going rate in the summer of 2005. For every $100,000 borrowed, you’d pay $600 a month.
After five years, principal payments would have reduced each $100,000 to about $93,000. Today you could refinance that balance with a new 30-year loan charging just 4.6% for a monthly payment of $477. That’s a 20% cut in payments, which is nothing to sniff at.
But by taking out a new 30-year loan, you’d add five years of payments before the loan was paid off. On the original, 6% loan, you’d already have paid $29,027 in interest. Now you’d pay $78,633 in interest on the new loan. The grand total, $107,838 is only a slight savings over the $115,838 you would have paid if you had kept the original loan for 30 years.
Once the appraisal, application fee and other closing costs are added, the refinancing might save you nothing.
This is why advisers traditionally suggest matching the terms on the old and new loans. Since you might not find a loan matching the time remaining on the old one, you could use extra principal payments to pay the new loan off on the same date you would have paid off the old one.
By paying an extra $50 a month toward principal, you could retire the new 4.6% loan in about 25 years. Reducing the rate and eliminating five years of payments would slash your interest payments to $62,497. With the two loans taken together, your interest would total $91,524, substantially less than the nearly $116,000 you would have paid on the original loan.
But what if your real problem is current expenses, not long-term interest charges? Suppose, for example, that you wanted to pay down credit card debt or pay a child’s tuition. In that case, it might make sense to extend the loan term as long as possible getting the payment as low as it can be. Consider if you were 15 years into a 30-year loan for $100,000, charging 8%. In that case, you’d be paying $734 a month.
By refinancing the remaining debt — $76,782 — of a 30-year loan at 4.6%, you could slash the payment to $394, saving $340 a month. If you’d started with a $300,000 loan, the refinancing would save you more than $1,000 a month that could be put to immediate needs.
Of course, your lifetime interest charges would go up to $173,777, compared to the $164,155 that you would have had if you kept the old loan. Still, once your short-term cash crunch is over, you can make extra principal payments to retire the new loan early, avoiding the extra interest tacked on by extending the term.
The option of refinancing to a loan with a longer term is something to keep in mind if you are wrestling with an immediate financial problem. Use the Mortgage Loan Calculator to play with the numbers.
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