Re-Fi Necessity: Crunching the Numbers

These days about three out of four mortgage applications involve a refinancing rather than a home purchase, which is understandable given today’s bargain rates and the risky housing market. But how many borrowers who expect to cut their homeownership expenses will increase them instead?

The culprit: a fixation on monthly payments without considering how, after a few years, a new mortgage can leave the borrower owing more than if the old loan had been kept.

Homeowners considering refinancing typically focus on two numbers — potential savings in monthly payments and the costs of refinancing, which includes “points,” application fees and other expenses that can run up to thousands of dollars.

Costs are then divided by monthly payments to determine how long it will take for savings to outweigh expenses. If the homeowner expects to have the loan longer than that, refinancing appears to be a profitable move.

But two other factors need to be considered. First is how much interest will be paid before the loan is paid off. A homeowner with 15 years left on a 30-year loan can lose money over the long term by refinancing to a new 30-year loan, even if monthly payments are smaller, because interest will be paid for twice as long. On the other hand, if the homeowner expects to sell in 10 years and pay off the loan, the refinancing could make sense.

But that depends on the other key factor: how much of the loan will remain to be paid off when the homeowner sells or refinances again? In many cases, a new loan will chip away at principal more slowly than the old one, leaving a bigger balance to pay off and undermining savings from a reduced monthly payment.

Mortgage and real estate expert Jack M. Guttentag, an emeritus professor at The Wharton School of Business, has a term for many borrowers. “They are payment myopic, which is a pervasive malady among households who never seem to be able to get out of debt,” he writes on his Web site, The Mortgage Professor.

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