Probably the second biggest mistake I see people make when refinancing their home loan is being talked into the maximum term by their broker or bank manager. The reasoning is sound – it will lower their repayments. But what about the long-term consequences? Well, they aren’t so great.
Basically you will end up paying more in interest if you extend the term. Here’s an example. Say you have $500,000 left on your loan and only 25 years remaining. The interest rate is 4.53%. If you refinanced back out to 30 years (ie increased the term by an extra 5 years) your repayments drop from $643 to $586. That is a saving of $57 per week. That is a great result – an outing with the family each week or maybe save it up over a year and you nearly have $3,000 for a family holiday.
But let’s take another look. The total interest you will pay over the term increases from $335,652 to $414,621 – a whopping increase of $78,969! It’s even worse if you refinanced from 20 to 30 years – you would save $145 per week but end up paying $154,175 more in interest!
Don’t be seduced by weekly savings if the term is increasing! You must understand the overall picture.
Why won’t the banks tell you this?
It is in the banks interest (no pun intended) to have you tied to them longer. The longer you are a client paying off debt the more money they stand to make from the interest repayments you will pay over time.
What about mortgage brokers – aren’t they required to tell me?
Some mortgage brokers wouldn’t tell you because of two main reasons. Firstly, it appears as if the loan is much cheaper by extending the term. Technically it is cheaper because your regular repayment will be lower thanks to the longer term. That can be good but not at the expense of a higher interest bill over time.
Secondly, the majority of brokers take an annual commission from your loan. That is, the lender they use pays them a little bit of commission each year you hold the loan with that lender (they also get an upfront commission as well). These upfront and annual commissions can add up to tens of thousands of dollars.
So what can you do?
You need to look at the whole picture. Below I have created a calculator that illustrates 3 scenarios. I have ignored the example above where you refinance at the SAME rate. Let’s face it – if you are going to refinance you might as well chase a better rate as this gives you options. There are 3 scenarios.
Scenario 1 (the “I need to maximise cash flow NOW” approach):
- refinancing to a new, lower rate and longer term
- the weekly repayment reduces
- BUT, you will end up paying more interest
- great for those wanting to free up as much cash flow NOW and don’t mind paying for it later on via a higher interest bill
Scenario 2 (the “have your cake and eat it” approach):
- automatically finds the term where you pay less each week but without increasing the total interest paid
- still provides extra cash flow each week without costing you any more over the long run
- great for those wanting to have more spare cash to live life NOW or that want to start investing NOW rather than after the home is paid out.
Scenario 3 (the “I want to save time AND money” approach):
- assumes you will keep your repayments the same for the new loan
- automatically finds which loan term to refinance to at the new rate to keep the repayments roughly similar
- will save you time and a lot of interest
- great for those comfortable with current repayments and wanting to own their home sooner and save interest paid
3 different scenarios all with different goals and needs. At Moneybright my philosophy is that everyone wants different things and I aim to provide real financial choice when it comes to making important decisions. Refinancing is not just a simple act of extending the loan as long as possible and crossing your fingers. There are consequences for every choice.
Enjoy the calculator (just plug in your details) and feel free to contact me to discuss the results on a personal level in the context of your own circumstances.
WARNING: Please don’t forget the General Advice Warning in the footer.