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Three Rules of Thumb for
Mortgage Refinancing by: Stephen L. Nelson, CPA You might think that deciding to refinance a mortgage with bad credit requires only a quick comparison of bad credit 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 bad credit loan balance, and the bad credit loan term period. When people refinance, they tend to focus solely on the bad credit loan interest rate. But they often don’t pay as much attention to the bad credit loan term or the bad credit loan balance. When you use refinancing—even refinancing at a lower interest rate—to 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 bad credit loan—this is the best measure of the new bad credit loan’s interest rate cost—and then compare this to the bad credit loan interest rate on your old bad credit loan. You don’t want to compare interest rates on the two bad credit loans nor do you want to compare annual percentage rates on the two bad credit loans. Again, just to make this perfectly clear: You want to compare the bad credit loan interest rate on the old bad credit loan to the annual percentage rate on the new bad credit loan. When the annual percentage rate on the new bad credit loan is lower than the bad credit loan interest rate on the old bad credit loan, then you are truly paying a lower interest rate. Comparing annual percentage rates with bad credit loan interest rates seems confusing at first. But note that you would pay only interest on your old or current bad credit loan, so that’s all you need to look at in terms of its costs. With a new bad credit 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 bad credit 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. |
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