Three Rules of Thumb for Mortgage Refinancing by:Stephen L. Nelson, CPA

You might think that deciding to refinance a mortgage requires only a quick comparison of loan interest rates

. Unfortunately, that's not really true. Refinancing is trickier than that! Fortunately, three useful rules of thumb can often help you make sense of refinancing opportunities.

Rule 1: Don't Ignore Total Interest Costs

You really want to use refinancing as a way to reduce the total interest cost you pay. While that sounds simple in principle, it is sometimes difficult to do. The interest costs you pay are a function of the interest rate, the loan balance, and the loan term period.

When people refinance, they tend to focus solely on the loan interest rate. But they often don't pay as much attention to the loan term or the loan balance.

When you use refinancingeven refinancing at a lower interest rateto increase your borrowing or to extend the time over which you borrow, you often aren't saving money.

Rule 2: Trade Expensive Money for Cheap Money

For refinancing to make economic sense, however, you do need to swap higher interest rate debt for lower interest rate debt. This calculation, however, is tricky. To make an apples-to-apples comparison, you must look at the annual percentage rate that will be charged on your new loanthis is the best measure of the new loan's interest rate costand then compare this to the loan interest rate on your old loan.

You don't want to compare interest rates on the two loans nor do you want to compare annual percentage rates on the two loans. Again, just to make this perfectly clear: You want to compare the loan interest rate on the old loan to the annual percentage rate on the new loan.

When the annual percentage rate on the new loan is lower than the loan interest rate on the old loan, then you are truly paying a lower interest rate.

Comparing annual percentage rates with loan interest rates seems confusing at first. But note that you would pay only interest on your old or current loan, so that's all you need to look at in terms of its costs. With a new loan, however, you would pay both interest and any origination or closing cost fees. The annual percentage rate wraps the interest rate charges and setup charges, origination charges, and closing cost fees into one interest rate-like number.

Rule 3: Don't Lengthen the Repayment Period

Be careful that you don't extend the length of time you borrow by continually refinancing. For example, one common rule of thumb states that every time interest rates drop by two percentage points, you should refinance your mortgage. However, there have been times in recent history when following this rule would have had you refinancing your mortgage every few years. This could mean that you would never get your mortgage paid off. If you refinanced every few years, you would suddenly find yourself still 30 years away from having your mortgage paid.

About the author

Bellevue WA accountant Stephen L. Nelson, CPA, MBA is the author of both Quicken for Dummies and QuickBooks for Dummies and an adjunct tax professor for Golden Gate University's graduate tax school.

steve@stephenlnelson.com

POST COMMENT

Picking A Small Business Accounting Program by:Stephen L. Nelson, CPA Survival Without Computers by:Kerri Salls Business Growth Requires Individual Effectiveness by:Kerri Salls Finders Keepers by:Kerri Salls Summer Sales Doldrums - What To Do by:Kerri Salls Buying A Car - What Is The Best Finance? by:Joseph Kenny Credit Rescheduling by:Joseph Kenny Loans For Self-Employed by:Joseph Kenny Brain-dead Mutual Fund Selection by:Stephen L. Nelson, CPA Quicken Investment Recordkeeping Tricks by:Stephen L. Nelson, CPA VOIP Small Business/Home Business Advantage by:Joel Walsh Why Bother With Distributed Leadership? by:Kerri Salls Empathy 101: Ten Commandments Of Human Relations by:Kerri Salls