September 24, 2021

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Resetting the Clock When You Refinance

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Mortgage rates are trickling back toward record lows again and refinance applications are on the rise.

You can thank our questionable economy, a COVID resurgence, and the Fed’s pledge to continue buying mortgage-backed securities.

The recent announcement regarding the end of the Adverse Market Refinance Fee is also undoubtedly helping.

My expectation is we’ll see a big jump in refinance applications when the Mortgage Bankers Association (MBA) reports the data tomorrow morning.

While the rally could be short-lived, it may renew interest for some that were on the fence about refinancing, especially if their current interest rate isn’t all that high compared to current market rates.

What Does It Mean to Reset the Mortgage Clock?

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Mortgage term: 30 years
Age of mortgage: 5 years old
Time left on mortgage: 25 years

When you refinance your mortgage, there are lots of implications. It’s not just about a lower monthly payment, despite that being the chief motivation.

There’s also the cost and time involved, the product you choose, the status of your existing mortgage, along with what you plan to do post-refinance.

One thing some homeowners might overlook when refinancing is their mortgage term, seeing that most individuals tend to focus on monthly payments above all else.

But when you refinance, you wind up with a new loan term and associated amortization schedule.

So if you previously had a 30-year mortgage that was five years old, and refinanced into another 30-year mortgage, your term would increase from 25 years back to 30 years.

A 35-Year Fixed Mortgage?

In this fairly reasonable scenario, a hypothetical homeowner would increase their collective loan term to 35 years as opposed to 30.

This matters. It matters because the longer you take to pay off a loan, the more it will cost you in the way of interest. This is one reason why 40-year loans aren’t very popular and all but extinct nowadays.

Sure, your monthly payment will be lower on a longer-term mortgage, but you’ll pay a lot more interest and build home equity much more slowly.

So for those that refinance into a mortgage with the same term as the original mortgage, the clock is effectively reset. You’re back at square one, at least in terms of when your mortgage will be paid off.

Even if your payments are lower, you’ll still have to make another 360 payments (in the case of a 30-year loan) before you own your home free and clear, assuming you don’t pay it off early or refinance again.

Now the mortgage term isn’t the be-all and end-all because homeowners refinance for plenty of different reasons, but it is something you need to strongly consider.

Let’s Do Some Math to Illustrate This Clock Resetting Business

Original mortgage: $200,000 loan, 30-year fixed @6%
New mortgage: $186,000 loan, 30-year fixed @4.25%

Suppose a borrower has a $200,000 mortgage set at 6% on a 30-year fixed mortgage. They make regular monthly payments that push the loan balance down to roughly $186,000 after five years (60 months).

Then they decide to refinance into another 30-year fixed set at 4.25%, which lowers their monthly payment from $1,199.10 to $915.01, factoring in the slightly smaller loan amount of $186,000.

The monthly savings are nearly $300, which is great for payment relief, but if they hold the new loan to term, they’ll pay roughly $142,000 in interest.

Keep in mind that during the first five years on the original loan they paid about $58,000 in interest. That needs to be factored into the total equation as well.

In reality, this borrower will pay about $200,000 in interest when you consider the full 35 years of monthly payments.

However, had the borrower not refinanced, they would have paid about $232,000 in interest on the original loan. So there are still decent savings to be had, even when restarting the clock.

However, that was a near 2% drop in rate. What if it’s a lot less than that?

If our hypothetical borrower had an original interest rate of 5.25% instead of 6%, total interest paid over 30 years would be roughly $198,000.

After five years, they’d pay about $51,000 in interest, with a loan balance down to around $184,000.

If they refinanced to a 30-year fixed at 4.25%, they’d pay another $142,000 in interest over 30 years, or about $193,000 in total across the two loans. That’s only $6,000 less than the original loan had it been left alone.

Once you factor in refinance costs, assuming it’s not a no cost refinance, the savings could be negligible.

You Can Reset the Mortgage and Still Win

The obvious answer to this “problem” is to simply refinance into a shorter-term mortgage, such as a 15-year fixed mortgage.

That way your effective mortgage term is actually 20 years; five from the original loan plus 15 more via the refinance.

Throw in a lower interest rate (15-year fixed mortgages are cheaper) and the savings will be substantial.

We’re talking close to $100,000 less in interest paid. Not to mention you own your home a lot quicker.

But that involves a higher monthly payment, something not all homeowners are particularly fond of, especially when refinances are sold as payment relief.

After all, some borrowers just want to reduce monthly costs and put money elsewhere, such as in a retirement account or other investments that yield better returns.

There are also homeowners refinancing out of ARMs and into fixed mortgages, which resets the clock but puts the borrower into a loan they know will not adjust higher.

Look at billionaires like Facebook founder Mark Zuckerberg, who kept refinancing from ARM to ARM to save money. Sure, he can pay off his mortgage whenever he wants, but he’s still resetting the clock over and over again.

Other Options to Avoid Resetting the Clock

If you want to a lower interest rate on your mortgage, but also want to stay on track payoff-wise, you’ve got some other options.

One trick is to refinance from a 30-year loan into another 30-year loan at a lower rate, but continue to make your old monthly payment.

For example, if you were paying $1,200 per month and your new minimum payment is $900, keep paying $1,200.

This could save you a good amount in interest and shed years off your mortgage, making the combined term of both loans less than 30 years.

You also get to enjoy payment flexibility versus the more expensive 15-year fixed.

It may also be possible to obtain a more obscure type of loan, such as a 20-year fixed or maybe even a 25-year fixed instead.

And there are lenders out there that will let you choose any mortgage term you wish. So if you’re already six years into a 30-year term, they can give you a new 24-year fixed mortgage.

In summary, consider your loan term when you ponder a refinance. If you’re well into paying off your mortgage, there’s less incentive to refinance and reset the clock.

Remember, interest is front-loaded on mortgages. How much have you already paid and how much will you save with a new loan?

If it’s early days, you shouldn’t fret too much, but if you’re far along, take a moment to really run the numbers.

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