Despite the roller coaster-like ups and downs the housing market has experienced over the last several years, home ownership remains the key component of the American Dream for most people. But, even though we continue to enjoy some of the best mortgage rates in history, financing a home purchase is a financial obligation that can put a great deal of strain on family budgets.
The good news is that a mortgage is such a large and long-lasting debt that significantly cutting its cost can be done by making fairly minor adjustments to the loan terms. It might sound impossible, but reducing the cost of your home loan by $50,000 — or much more — doesn’t require any drastic moves at all.
Two Ways to Knock off $50,000 or More in Interest from Your Mortgage
Let’s use a 30-year fixed mortgage loan of $250,000 as our example. The following are two different refinancing strategies you can use to eliminate $50,000 in mortgage debt from your life.
Scenario No. 1: Reduce Your Mortgage Interest Rate by 1%
Mortgage interest rates have fallen dramatically in the last few years. According to HSH.com, the average interest rate for a 30-year fixed mortgage in 2008, just off the heels of the market crash, hovered above 6%. Today, mortgage interest rates for the same term average about 4.46%.
So consider the hypothetical mortgage loan above: If you just obtained financing on a home within the last several years and agreed to a mortgage rate of 6%, you can now refinance to, say, 5%. It doesn’t seem like much, but here’s how much you would save:
Using this mortgage calculator, we find that a $250,000 loan with a 6% interest rate, paid over thirty years, equals 360 payments (12 months multiplied by 30 years) of $1,499.
This equates to spending a total of $539,640 over the life of the loan. Subtract the initial principal of $250,000, and that leaves $289,640 worth of interest paid over the 30-year loan.
Now, calculate payments again with the lower interest rate of 5%. Instead, you would make 360 payments of $1,342, or $483,120 in total. Subtract the $250,000 principal and you’re left with $233,120 in total interest paid.
You just saved $56,520 on your mortgage.
Scenario No. 2: Cut Your Mortgage Term Length in Half
It’s easy for homeowners to get caught up in the size of their monthly mortgage payments, rather than consider the entire cost of the loan. Unfortunately, lessening monthly payments often greatly increases the overall amount of money you will pay for home financing.
Consider again the above 30-year fixed mortgage with a principal loan amount of $250,000 and the 5% interest rate. If, instead of opting for a 30-year term, you agree on a 15-year mortgage instead — and we’ll keep the interest rate at 5% for simplicity’s sake — you will significantly reduce the total amount of interest paid over the life of the loan.
According to the above mortgage calculator, a $250,000 loan at 5%, paid over 15 years equals a monthly payment of $1,977.
This is a much larger payment required every month, but consider this: $1,977 multiplied by 180 payments (15 years) equals a total loan cost of $355,860. Subtract the $250,000 principal and you’re left with $105,860 in total interest paid over the life of the loan.
By simply opting for a 15-year fixed rate mortgage rather than the 30-year as depicted in Scenario No. 1, you save $127,260 in interest. That’s more than one hundred grand to put toward other important goals like a college fund, retirement savings or investing.
Should I Refinance?
While the hypothetical savings are impressive, refinancing is not a one-size-fits-all solution to saving money on a mortgage. It’s important to consider things like closing costs and how far into your current mortgage you have already paid before changing the terms of your loan.
For instance, refinancing means ending an existing mortgage and opening a new one, whether that’s with your same lender or another. Closing costs must be paid to refinance a loan, just as they were to obtain your original loan. Ensure that the amount of the total closing costs doesn’t cancel out the savings you would enjoy from a decreased interest rate.
Secondly, when changing the term length of your mortgage, consider how long you’ve held the current loan. Your loan amortizes according to a schedule devised by your lender, and most amortization schedules allocate a larger percentage of monthly mortgage payments towards interest rather than principal in the initial years of the loan. As the home loan gets closer to being paid off, more of your payments go toward paying down the principal.
That means if you’ve held your current mortgage for a long time, much of the money you’ve put into it has already paid down a large portion of interest. Refinancing the loan with new terms might not be a wise move.
A mortgage will likely be the biggest financial responsibility you ever take on, so it’s important to be realistic about what you can afford. But when determining that number, don’t forget to consider the long-term costs of a home loan — especially how much interest you will pay in total — and don’t get stuck on that monthly payment figure.