Mortgage Myths – Part 2

This is part two of mortgage myths, part of EVERYTHING YOU THINK YOU KNOW ABOUT MORTGAGES IS WRONG. Most people think that the objective of refinancing is to lower your payment. Not so. In fact, this mindset gets a lot of people into trouble, causing them to make wrong decisions.

Each payment on a normal fully amortized loan has two components, interest and the amount applied to reducing the loan balance. That’s how it gets paid off eventually. At today’s rates the amount applied to principal reduction is about 16% of each payment. Most people don’t look at their mortgage payment coupon so it is not obvious. So you could theoretically reduce your payment by 16% just by going to an interest-only loan.

Let’s say you have a $200,000 loan and that the payment is $1,200, what it would be if the rate were 6%. You get a call and someone says, “I can reduce your payment to $1,000.” Sounds good, doesn’t it? But really all you are doing is cutting out the principal reduction part and the problem with that, of course, it that you won’t be paying off the loan off.

Even worse are the negative-amortized so-called “Option ARM’s” where you make an artificially low payment. On our example, you could get one of these loans which would have a payment of under $500. Going from $1,200 down to $500, sounds really good. The problem is that you aren’t even paying the interest that is due on that loan. The interest rate is actually about 7% today and the interest due is $1,116. The difference between the amount due and the amount paid, $616 in this case, is added to the principal balance. You owe $616 more, and you’ll start accruing interest on that amount too.

Note too that the actual interest you are paying on this loan actually goes up 11.6%, from $1,000 to $1,116. You paid all the costs of a refinance, lost your long-term rate protection, and you are actually paying a higher interest rate. Do people fall for this? Don’t kid yourself; this is America ’s most popular loan today.

The other bad part about 30-year loans relates to the nature of the amortization curve , which describes how a loan is paid off over its lifetime. I like to say that there are three parts to this curve – the stupid part, the OK part, and the good part. You can see how that works by looking at how much is paid off in each phase.

Why is this important? Consider this – the worst credit card management strategy in the world is to pay the minimum amount due every month. It’s like the debt never goes away. The lender loves it, of course, because they get paid interest on the balance, which never drops much. It maximizes their profit. It also maximizes your cost! By the same token, when borrowers make the obligatory minimum low payment on a 30-year amortized loan, they are falling in that same trap: maximizing the lender’s income, and maximizing their own cost! You don’t want to do that.

When most people refinance, they get it wrong! They focus on “lowering their payment” by getting a new 30-year loan. What they do is go back to the stupid part of the amortization curve again. If you are more than 5 years into your current loan, even if you lower your interest rate 1%, if you select another 30-year loan you actually may owe MORE TOTAL INTEREST than you owed on the old loan with only 25 years left.

A better strategy when you refinance is to keep making the same payment you are making now. At the lower interest rate, you’ll get into the better part of the amortization curve and knock even more years off the life of your loan, saving a bundle.

Be very careful out there.