How refinancing affects your home equity
One of the main reasons that people refinance is to lower their costs. Because of this, the focus is on their monthly payment. But, you should really refinance with your home equity in mind. After all, your ultimate profit on your home will come from the home equity you have, that you build by paying your mortgage every month and from appreciation. Home equity is the hidden lever that gives homeowners good outcomes. Let’s discover how refinancing affects your home equity.
Don’t just focus on monthly payment
Monthly savings is great, but you want to make sure you aren’t shooting yourself in the foot in other ways.
Mortgage loan officers like to sell on monthly payment for two reasons. One, it’s simple to understand, and two, because they can make a dog of a deal look like the deal of a lifetime. Take the following example: someone who has 20 years left on a 30-year mortgage with a remaining balance of $200,000 refinances and their payment drops by $200 a month. That sounds awesome, right? Not so fast. If the loan officer has taken the balance on a 20-year mortgage and stretched the payment back out to another 30-year mortgage, suddenly you’ll likely be paying a lot more interest on it and building equity more slowly. That means you can end up with way less equity in your home, which is where your profit comes from, when it comes time to sell. Not such a good deal after all.
There are many other ways to make a dog of a deal look like the deal of a lifetime by focusing on monthly payment. Monthly payment and stretching out the term can hide high refinancing fees, which are usually rolled into the loan amount, for example.
Instead, look at cost savings in relation to your home equity now and in the future
If you look at your home equity too, then it’s really hard to hide a bad deal, protecting you as a consumer. And, it’s easy to do. Just like you would add up your monthly savings, compare the principal payments you’d make with your current loan vs. your new refinanced mortgage.
Every principal payment you make reduces your debt, which makes your home equity go up. Home equity is where your profit is.
If you are paying $200 less per month for your mortgage payments, but you are making $250 less in principal payments per month, that means that you will have $250 less in profit when you sell. See what I mean?
When you start over with a new mortgage, you go back to the beginning of loan amortization, so, even though you might have a reduction in interest rate, you could still pay more in interest, and build equity much less slowly, which is a terrible deal for you!
If you want to learn more about amortization and home equity, I have a video here for you.
Paying attention to your home equity as much as monthly payment will prevent you from making a mistake in a refinance.
Pssst! Be careful with “break even” calculations, too.
One of the most common things that mortgage loan officers use to convince a homeowner to refinance is the “break even calculation”. This calculation tells you after how many months you will recoup the fees you paid for a refinance with monthly savings. For example, if you pay $5000 in fees to refinance, but you save $500 in monthly costs, your break even would be $5000 / 500 = 10 months. It takes 10 months of paying less per month to recoup the costs.
But this formula is all wrong. Watch this short video which explains why.