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Refinancing Your Home Might Cost You in the Long Run

By Larry Swedroe

Updated on: September 14, 2010 / 11:35 AM EDT / MoneyWatch

With mortgage rates near historic lows, perhaps you've spoken to someone about refinancing your mortgage. Before you jump on what seems like a great opportunity, you need to look at the costs correctly. My Buckingham Asset Management colleague Jim Cornfeld shared the right way to consider the costs of refinancing.

It seems like an easy decision -- compare your lower monthly payment after the refinance with the up-front costs. However, like so many things we see in personal finance, your decision isn't quite that easy.

Let's look at an example. Assume you have:

Twelve years remaining on your 15-year mortgage
An interest rate of 4.75 percent
Remaining principal of $150,000
A monthly payment of $1,369

Your mortgage broker offers a 15-year mortgage at 3.875 percent with monthly payments of only $1,100, saving you $269 per month. To do this, you will need to pay up-front costs of $3,000. When you compare the monthly savings to the costs, it looks like you have a breakeven of less than one year, right? Not really.

Payment of Interest Vs. Principal First, your monthly payments are made up of principal and interest. While payment of interest is a real cost and should be compared when determining breakeven, payment of principal is not and should not. Principal increases ownership in the property and will be recovered upon sale. What you're really doing with the principal portion is taking money out of one pocket and putting it into another.

So what are you really saving here? In the early months, you would be paying about $109 per month less interest, with those savings going down over time. It will be 33 months before you save enough interest to offset the $3,000 up front costs.

Taxes Because your interest payments are tax deductible, the government shares in your interest savings. Also, your up-front costs aren't deductible, so you need to compare the after-tax interest savings with the full $3,000 up-front cost to get a true breakeven. If you're in a 25 percent Federal tax bracket with no state income taxes, your true breakeven will occur at 50 months. That's quite a bit longer than one year.

Finally, if you're staying in your home, you will pay $47,000 (before tax) of interest over the remaining term of your existing mortgage. If you refinance, you will pay $48,000 of interest over the 15 year term. Remember, even though the interest rate is lower, you'll pay for an extra three years. (And this is on top of the $3,000 you paid up front.)

This doesn't mean you shouldn't consider refinancing. You just need to consider the full costs when you refinance. For example, consider increasing your monthly payment on the refinanced mortgage so that you'll pay it off in the same time frame as your existing mortgage. Using our example above, your monthly payment would be $1,304 per month, or about $204 more than the 15-year mortgage payment, but still $65 less than your current payment. The after-tax breakeven would be 40 months, and you would save almost $9,300 of interest (before tax) over the life of the mortgage. A final word of caution: When you make the higher payment, you'll need to confirm that the extra amount will be treated as payment of additional principal.