The Most Costly Mistake
In Luke 14:28, Jesus said "For which of you, wishing to build a building, does not first sit down and calculate the cost (to see) whether he has sufficient means to finish it?
Jesus here was communicating plainly to crowds about what was required to be His disciple, however the wisdom he spoke of here is invaluable to us in the area of borrowing - and especially when it comes to refinancing.
Because of the great expense a home purchase is and the length of the contract, any error we make in the contract can cost us enormously and for a long time. With refinancing, the most costly mistake is to focus on monthly payments alone. When you refinance, you're restarting the clock on that loan, so if you've been paying your loan for a while, the new loan could leave you with a longer payoff timeline.
Stretching out your repayment schedule is often enough to reduce monthly payments by itself (regardless of the new interest rate... think about that and why it is). The trouble is that if you make the payments last longer, you'll also pay a ton more in interest over time.
That is why we must heed the words of Jesus above... to sit down and calculate the cost. To decide if refinancing really makes sense, look at both the projected new monthly payments and total interest costs. If you can reduce both, then you're in great shape. To put it in the most simple math and terms, if you currently owe "X" amount in total payments, and the new loan amount of the total payments is greater than "X", you will be worse off as you're only trading smaller payments in exchange for a larger total loan amount.
It can still be beneficial if you can reduce your interest rate and your payoff time, even if you don't reduce your monthly payments. Because in this scenario, you'll pay less over time and can become debt free faster.
One of the most eye-opening documents to see and understand to help in this area is the Loan Amortization Schedule, because it shows exactly the breakdown of your current payment - how much goes to Principal, how much to Interest, and the ongoing Balance you have remaining. Look at the data below for a new loan of $500,000 at a 5.25% interest rate:
See how in this first payment that $2,187 is going to pay Interest, while only $573 is reducing the Principal? If it feels like you are paying 79% Interest, you are right - it's really only a 5.25% loan if you pay if off in one year.
It will take nearly 17 years... all the way until May 2039 before the amount of Principal reduction each month finally becomes more than the Interest paid. By this time you've sent in over $373,000 in payments, but only reduced your Balance by $187,000:
