Should I refinance my mortgage at a lower rate, but longer term?

So you've been making payments on your mortgage for the past five years and are thinking about refinancing because rates are dropping. You've heard that you can lower your monthly payment by refinancing into a new 30-year mortgage and that you'll save a lot of money on interest due to the lower rate, right? Before you pull the trigger on a mortgage refinance, you should educate yourself on both the benefits as well as the downsides when refinancing your mortgage at a lower rate, but longer term.

Lowering my monthly mortgage payment, but extending the loan term

When you refinance into a mortgage with a lower interest rate, it results in a lower minimum monthly payment to the lender. However, if you are refinancing into a new 30-year mortgage, you're essentially resetting the loan term to another 30-years compared to the remaining term on your current mortgage. For example, if you've been making payments for the past 5 years, you should have 25 years left on your current mortgage. Once you refinance, you are starting over and have another 30 years left, albeit at a lower monthly cost.

Having a lower interest rate, but paying more total interest over time

A not-so-obvious downside to refinancing is that you may actually end up paying MORE total interest on your new mortgage compared to your old mortgage, even though you're refinancing at a lower interest rate. This can happen when you refinance into a new 30-year mortgage after having already paid several years into your old mortgage. The reason is because you will be making payments on your new mortgage for 30 years, and even though the monthly payment is lower, over time the total interest adds up to more than if you just stayed with your old mortgage.

The so-called "break even point" in a mortgage refinance

The phrase "break even point" is often used by loan officers and lenders to describe how long it takes before the monthly savings from your new refinanced mortgage exceed the closing costs you had to pay on the refinance transaction. For example, if you have to pay $1000 closing costs on a new mortgage refinance, but your new monthly payment saves you $100 per month compared to the old mortgage, then your "break even point" would be in 10 months (10 x $100 = $1000).

Are you really "breaking even"?

It could be argued that the term "break even point" is somewhat confusing because it might give you the impression that your new mortgage is performing better than your old mortgage after you pass the break-even point. This is not accurate. The break-even point is really just looking at things relative to the closing costs of your new mortgage. It has nothing to do with comparing your old mortgage to the new one. Once you pass this so-called break-even point, you're still making regular payments on your new mortgage, and over time the interest on these payments could easily add up to more than your old mortgage depending on how many years were left on your old mortgage. On the other hand, if you make extra principal payments each month on your new lower-rate refi, then you can reduce the total interest paid.

Break even relative to closing costs, not total costs

As mentioned above, the break even point is only concerned with the "closing costs" that were required to start the new loan. However, it doesn't factor in the total interest costs over the life of the loan. If you're extending your mortgage for another 30-years, then you may well be paying more total interest even if you are getting a much lower rate than your current mortgage.

Closing costs of a mortgage refinance

When you refinance your mortgage, you usually have to pay some closing costs up front. These can cost thousands of dollars. It takes time before you reach a "break even point" where the savings of your new mortgage are greater than the closing costs. When you are considering a refinance, one calculation you should do before proceeding is to see what it might look like if you paid down your old mortgage's principal by the amount equivalent to what the closing costs for a new refi would be. For example, if a new refinance would require $5000 in closing costs, see what it looks like if instead you paid $5000 right now into your old mortgage principal. Most likely this will have a positive effect on reducing your loan term by a little as well as reducing the total interest of the mortgage.