How Low Interest Rates Can Kill You Financially
Are Refinances Good?
At the time of this writing interest rates are very low. Many people, if not upside down on the value of their homes, are trying to refinance their home mortgage in order to take advantage of the low interest rates that are available.
I am sure you have heard the advertisements, "Take advantage of the lowest rates in a decade" or something like that. But is it wise to refinance? Most people say yes, some will say if you are saving at least one percentage point, others look at how long you will keep your home in order to determine if the savings will offset the cost of originating the new loan.
But in this HUB I would like for you to look at interest a little differently because it is easy to make a wrong decision.
Doing the Math
Let's say, for example, that you have a mortgage or you are obtaining a $200,000.00 loan for the house that you want to buy and that the current interest rate is 4%. Most of us would think that 4% is a great deal, but are you really paying only 4%?
Most mortgage loans are written with a 30 year term, but on average that loan is only kept for 7 years before the house is sold or the mortgage is refinanced into a new loan. So did that loan only cost you 4%?
On this loan your principal and Interest payment would be 954.83 (this does not include taxes and insurance). Over the course of seven years you would have paid $80,205.72 in payments of which $27,880.90 went to principal reduction.
In other words, $52,324.82 of your $80,205.72 was your cost of using the money (interest). If you do some basic division you would find that 65.24% (.65 cents) of every dollar paid went to interest. Does that sound like 4% to you?
Let's take this same loan and extent it out to the 180th payment (15 years). At that point in the life of this 30 year loan the total payments are $171,869.40 with a principal reduction of $70,914.14 or $100,955.26 going to interest. This means that 58.74% (nearly .59 cents) of every dollar paid is going to interest. Notice that the interest charges are dropping.
If you were to continue calculating out as the loan matures you would find that you would eventually reach your 4% cost. Why is this? Because the way loans calculate the interest you end up paying all your interest up front.
So let's say that you bought a house 5 years ago and interest rates drop 2%. Is it smart to refinance? Have you ever wondered why your lender is happy to help you refinance to a lower rate? Did you really think they are looking out for you when they are in the business of making money?
No, the answer is that they understand the volume of interest is more important than the rate of interest. If you were to refinance the loan at this point in order to save two percent you will recharge the high volume of interest that is going to be charged on the new loan. This is why shortening the term is always the best idea in refinances not just lowering payments. Your payment is NOT the cost of your loan.
Making This Information Applicable
Look at your financial life and ask yourself how often you refinance, pay off early, sell, or cut short a loan that you have obtained? For most this is a never ending cycle. A person will go out and buy a new car and finance it on five years then trade it in after three years and think that the rate they paid on their car loan was 3% (or whatever they got). The actual numbers can easily be above 15%.
Understanding how interest works is one of the major keys to financial success. Unfortunately many, while trying to make prudent decisions, hurt themselves because of a lack of knowledge. I have seen so many wonderful people focus on the payment as the cost of the loan.
I can afford this house, car, or whatever because the payment is only $xx.xx. If you are only focused on the payment then you will live a life that lines the pockets of your local finance company.