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Beware the Hidden Costs of Refinancing

Contributed by mm | August 17, 2004 10:50 PM PST

When I saw the title of this MSN Money article, I thought it is about hidden closing costs and how to make sure a good faith estimate is really a good one. Well, Liz Pulliam Weston did mention that, but only at the very end of the article. Before running into the topic of closing cost traps, Liz spent considerable length to describe the other type of "hidden costs" -- additional interest even at lower interest rate.

Her theory: if you refinance your 30-year loan after 3, 5, 7 or 10 years, your mortgage broker actually woos you to pay more interest in the long run, because when you refinance, you also put off your payoff date by 3, 5, 7 or 10 years. In a mathematical example, Liz suggests that if someone is 10 years into a 7% 30-year fixed mortgage, and refinances to 5.5% 30-year fixed mortgage, he is going to overpay $26,413 in interest.

Did it shake your belief that you should always refinance to a lower rate if the closing cost is reasonable (or there is no closing cost)? Don't worry; Liz is wrong.

Why?

Because money has time value. As a simple example, let me ask you: will you give me $1 million today and think it's fair for me to give you the same $1 million back after 40 years? Of course you will say no.

If you are really into financial analysis, you will never add up cash flow happening in different points of time. By computing the simple arithmetic sum of the total interest paid throughout the lifetime of a mortgage, Liz is commiting the mistake by treating a dollar 40 years down the road the same as a dollar tomorrow.

Yes, if you refinance your 30-year mortgage after 10 years, you will pay more interest in dollar terms, but if you include the time value of money, refinancing to a lower rate loan (assuming a reasonable closing cost) almost always makes sense. Bottom line, if you have 20 years remaining in your 30-year mortgage and you refinance to a lower rate 30-year one, you can always continue to pay the same original monthly payment, and I can guarantee you that you will pay off the entire loan before the end of your original mortgage term.

(If you are still unconvinced, consider this: will you refinance your 6% 30-year mortgage into 7% 15-year mortgage? You will surely save interest on the absolute dollar amount basis, but you will not refinance, will you?)

In conclusion, total interest paid is never a good measure of whether a mortgage is better than another. The interest rate isn't either. APR is a better benchmark, especially when you are comparing a fixed rate mortgage with an adjustable rate one.

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