Wednesday, December 24, 2014

Serial Refinancing Calculation Example



Is refinancing your home a good idea?  Maybe once.  If you are doing more than twice, ask yourself where this is going.

As I noted in another posting, refinancing your home, again and again, can be a really bad idea.  And one reason this is so, is that the first few years of a mortgage are almost all interest payments.  So each time you refinance, you reset the mortgage clock, and start paying those huge interest payments over and over again.   You end up paying a lot more interest, over time.

How much more?  Let's do some calculations.

Assume our home loan amount is $250,000 for all examples (and the homeowner doesn't just keep rolling more and more debt into the loan over time and increasing the balance).

1.  No Refinance.  Consumer borrows $250,000 at 6.5% and pays if off over 30 years.  The monthly payment is $1508.17.  They pay $542,941.20 over 30 years (more than twice the principal amount!) and a total of $318,861.22 in interest payments.  They then own the home, free and clear.

2.  Serial Refinance.  Every five years, the consumer gets into trouble financially, usually due to credit cards and car loans, and decides to refinance - six times - each time taking advantage of lower interest rates.
A.  Consumer borrows $250,000 at 6.5% and pays for five years.  pay $1,580.17 per month, for a total of $78,837.65 in interest, reducing the principal to $234,027.44.

B.  Consumer borrows $250,000  (adding in credit card debt and closing costs) at 6.0% and pays for five years.  They lower their monthly payment to $1498.99 a month, for a total of $72,568.47 in interest, reducing the principal to $232,635.89

C.  Consumer borrows $250,000 (adding in credit card debt and closing costs)at 5.5% and pays for five years.They lower their monthly payment to $1419.47 a month, for a total of $66,319.86 in interest, reducing the principal to $231,151,51

D.  Consumer borrows $250,000 (adding in credit card debt and closing costs)at 5.0% and pays for five years.They lower their monthly payment to $1,342.05 a month, for a total of $60,095.07 in interest, reducing the principal to $229,571.83

E.  Consumer borrows $250,000 (adding in credit card debt and closing costs)at 4.5% and pays for five years.They lower their monthly payment to $1266.71 a month, for a total of $53,897.59 in interest, reducing the principal to $227,894.79

F.  Consumer borrows $250,000 (adding in credit card debt and closing costs)at 4.0% and pays for five years. They lower their monthly payment to $1193.54 a month, for a total of $47,731.08 in interest, reducing the principal to $226,118.78
A total of  $379,499.72 is paid in interest over 30 years - with $84,100.92 left still to pay - as well as a balance of $226,118.78. 

The person who owns their home, free and clear, pays only $318,861.22 in interest payments, saving $60,638.50 in interest.  They also owe nothing on their home, while the other person owes $226,118.78.  So they come out $286,757.28 ahead, even paying the higher interest rate - more than a quarter-million-dollars.

If a consumer keeps refinancing (and many do) they end up facing retirement still owing what they paid for the house when they bought it 30 years ago.   They also ended up paying, over the years, a staggering amount of interest, as well as transaction fees from all these refinances.

The problem is, due to the nature of compound interest, you end up paying the most in interest at the front-end of the loan.   If you continually refinance your loans, you keep paying the most in interest.

If the borrower continues to pay off this last note, they will be over 80 years old when it is paid off, and will have paid $463,600.64 in interest over that time.   That's a lot of money to pay in interest.

Think this scenario is far-fetched?  It ain't.   I refinanced my house twice.  I know many more who did it three, four, five or even six times - each time the result of getting into debt and using their home's "equity" as a "way out" of their debt problems - only to pour gasoline on the fire.

And the scenario I paint here is a rosy one.  Many folks refinanced and "took out" cash and actually increased their loan balances over time.  I know I did.   Many others did as well.   So not only does the loan balance not get paid down it actually goes up over time to the point where the homeowner's monthly payments keep going up and up and up.....

What is the answer?

If you refinance, do it only because you want to save money on interest.   Set the term for your new loan to be less than the old one - so you end up paying off the loan over time.  Resist the urge to run up credit card (and car payment) debts and then pay them off through refinancing.

But what if you don't refinance?   This same effect can bite you on the ass even if you are an "ordinary American."

The average American moves every five years or so - according to Real Estate companies.  So if you keep buying a new house and then getting a new mortgage, the effect is the same.  That is, if you keep borrowing the same amount of money and resetting the mortgage clock.

It is tempting, when you sell your home, to take the equity and spend it.  You may put down the minimum necessary for a down payment on the new home - and then spend the rest on remodeling, repairs, and new furniture.   I've seen it done.   You see people buy a home and immediately rip it apart and spend $100,000 in remodeling.   Where do they get the money?  Answer:  From the equity in their former home.

The problem with this model is that while you have a fancy house, you end up on the debt treadmill for another decade or so - well into retirement.   And you end up paying the most, in terms of interest.

So, you refinanced already - and took cash out to pay off a car loan and three credit cards.   What do you do?  

Well, avoid the temptation to do it again.  It is easy to run up more debt, particularly now that your credit score shoots up and the credit card company says, "Congratulations!  We've raised your credit limit!"

Sadly, most of us never figure this out.  It is like the time I got three speeding tickets in one weekend.  My Lawyer told me, "Maybe this is a good time to re-examine your driving habits" and that was good advice.  Instead, I decided to speed for another decade - and pay horrendous insurance premiums.

The same is true for refinancing.  When we refinanced the second time (and took cash out to pay off debts) my friend who was a mortgage broker advised that we should re-examine our spending habits - "or you will be in the same boat in another five years."   She was right, but sadly that advice also fell on deaf ears as well.

When you borrow more and more money, you are not "getting ahead" just because you managed to lower the monthly payments.   When you take on more and more debt, your net worth declines accordingly.

Take action, before it's too late!

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