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| The Basics | Beware the hidden costs of refinancing
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Many of todays homeowners are chasing low interest rates in fiscally foolish ways. What you dont know about the refinancing game can cost you dearly.
By Liz Pulliam Weston
As mortgage interest rates continue to ebb and flow at unusually low levels, a new kind of homeowner is emerging: the serial refinancer.
Mortgage brokers say theyre dealing with an increasing number of borrowers who have replaced their mortgages two, three, four or even more times. But continually refinancing, while it may be good for the U.S. economy, carries some hidden costs that few mortgage brokers will tell you about.
Endless interest
The most important and least understood of these costs is total interest. In the early years of a mortgage, youre paying mostly interest. During the first three years, 85% of your payments are interest, so that on a $200,000 loan with a 7% interest rate, your balance is still more than $193,000 after three years, despite the fact that you've made more than $48,000 in payments.
That's the way loan amortization works. Even though your payments may be fixed for the life of your loan, it's not until you've made more than 20 years of payments in the example above that the amount going to repay principal exceeds the amount going to pay interest.
Now suppose that you refinance after three years with a new 30-year loan at 5.5%. You start with that $193,000 balance, add a couple thousand dollars in fees and begin the amortization process all over again.
If you keep replacing one 30-year mortgage with another, youre putting off the day when your payments will significantly build your equity. In essence, youre "renting money" by staying in continuous debt, rather than building wealth by paying down that debt.
The refi scenarios
And the longer youve had a mortgage, the more cautious you should be about trading it in for another 30-year loan. If youre more than seven years into your loans term, you could end up paying more in the long run, even if the new mortgages monthly payments are significantly lower.
I hear from people who are five years into a 30-year mortgage who want to refinance to another one thats 1.5% lower, said Diane St. James, a consultant who runs a mortgage education Web site called ABC Mortgage Consulting (see link at left under Related sites). I tell them to at least go for a 25-year loan, St. James said, so theyre not starting over.
The chart below shows how the advantages of a 1.5% drop in interest rate disappear if you're more than seven years into your original loan, and this is true whether you refinance once, twice or 10 times during this period.
| Disappearing advantage | | Event | Remaining balance | Interest remaining | Payment | Interest paid | Total savings (or cost) | | Original loan at 7% | $200,000 | $265,172 | $1,331 | | | | Refi at 5.5% in Year 3 | $193,252 | $237,752 | $1,097 | $191,258 | $46,494 | | Refi at 5.5% in Year 5 | $188,031 | $211,008 | $1,251 | $186,090 | $24,918 | | Refi at 5.5% in Year 7 | $182,295 | $185,042 | $1,035 | $180,412 | $4,630 | | Refi at 5.5% in Year 10 | $176,042 | $147,810 | $1,000 | $174,223 | ($26,413) |
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Now let's look at the multiple-refi scenario and use real mortgage rates from the past 10 years. The table below assumes that the borrower refinanced with a new 30-year term each time.
What will surprise some, including many serial refinancers, is that even though refinancing dropped the interest rate a full 2 1/2 points from 8% to 5.5%, the total interest costs are more than $7,000 higher for refinancing than for keeping the original loan. Thats because the term of the loan is extended by an extra 10 years.
| Cost of serial refinancing | | Remaining balance | Total interest | Payment | Interest paid | Cumulative interest | | New loan at 8% in '93 | $200,000 | $312,483 | $1,468 | $78,191 | $312,483 | | Refi at 7% in '98 | $189,940 | $250,232 | $1,264 | $64,674 | | | Refi at 5.5% in '03 | $178,573 | $200,394 | $1,014 | $176,730 | $319,595 |
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(The above examples assume that you don't do a "cash-out" loan that increases the principal amount you're borrowing and that all refi loans are "no-point, no-fee" loans.)
The same logic applies when you move, as well, if you take out a new 30-year loan. And in a society where households move every seven years on average, many people wind up "renting money" for most of their lives.
Junk fees
You can land the best interest rate in the world and still end up shelling out too much for your loan if you dont pay attention to fees. The more often you refinance, the more often you risk being stuck with junk fees -- inflated or bogus charges that serve only to pump up profits for the broker or lender.
Fees typically come in three flavors:- Broker or lender fees (administration, document preparation, processing)
- Third-party fees (for appraisals, title searches, inspections)
- Government fees (usually the cost of recording the deed)
Fees are separate from points, which are a percentage of the loan, and from costs such as interest, property taxes and insurance, which will vary depending on when your loan closes.
The first two groups of fees are the ones most likely to be padded. Theyre also the ones on which you can often negotiate a discount, as long as you know in advance how much your lender or broker is planning to charge. Lenders are supposed to provide a good faith estimate of their closing costs early in the lending process to give you time to review and, possibly, bargain for reductions in some of the fees.
Unfortunately, this document might as well be labeled a bad faith estimate in the hands of some lenders and brokers, who tack on surprise charges at closing. No, theyre not supposed to do that, but yes, the bad ones do because theres little power in the laws designed to prevent such gouging.
How can you protect yourself? Consider dealing only with lenders, brokers or Web sites such as E-Loan that guarantee their fees up front and in writing. Or talk to your friends and relatives who have refinanced to find out which companies played fair and which played gotcha.
Take the time, as well, to educate yourself about what fees are reasonable. Bankrate.com has a survey showing the range charged by various lenders for a variety of fees. (See the link at left under Related sites.)
Whenever I write about junk fees, by the way, I get mail from brokers and loan officers who whine that such fees are the only way they can make a profit. But remember, you arent responsible for insuring the broker gets to buy a new Mercedes this year. Youre responsible for getting the best deal you can.
Its easy to get caught up in the frenzy of lower interest rates. But a cool head and a little analysis now can save you a lot of money over the long haul.
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