I know a lot of people who think that your US mortgage "restarts" if you refinance. That is not true. If you are able to refinance your mortgage with a new rate just ~~.25%~~ a little bit lower than your current rate, the cost of refinancing can pay off within just a year!
A little bit of "Mortgage theory"
Each and every mortgage payment you make is the sum of three components:
- The interest on your total balance (balance=the amount you owe), which is exactly the interest rate you have (APR) divided by 12 (because the "A" in APR means annual, and you make 12 payments, once per month in a year). This is the what I will call the basic rule of mortgages.
- A principle payment that is exactly what is necessary to cause your mortgage, with your given the APR, to be totally paid off after the duration of your mortgage.
- If you have an "escrow account", then there is an addition of property taxes and property insurance which is independent of the above two.
For a normal fixed-rate mortgage, the sum of 1. and 2. above will never change. Gradually, 1. will decrease and 2. will increase.
What happens when you do a refinance
Every time you make a payment, the part of your payment that goes to "principle" changes what you owe, by making it decrease a little bit. As a consequence, your costs go down if you can lower your APR. You can lower your APR by refinancing, and refinancing doesn't change your principle; what you've already paid off is what you've paid off.
When you refinance, you, do effectively "restart your mortgage", which is probably why the myth I'm discussing here is so stubborn! You had a 30 year mortgage, you were paying it off for 10 years, and then you refinance and you have a 30 year mortgage again. That sounds like a bad deal, but here's what you're missing:
- You can just get a 20 or 15 year mortgage instead of a 30 year mortgage. You could get a 15 year mortgage and maybe have a higher monthly payment, but pay off your mortgage 5 years early and save hundreds of thousands of dollars. Generally, shorter mortgages have a lower interest rate, saving you even more!
- You can get a new 30 year mortgage at a lower rate, and overpay it, making your monthly cost effectively the same, but you still pay off your mortgage years early! I'm not even sure it's possible to get a mortgage that penalizes paying off a mortgage early.
Sometimes, people say "you pay the interest first". This is simply not true! This is the main crux of this myth. No, you do not pay interest first! You only pay the interest on the existing balance. It just seems that way, because, per my basic rule of mortgages, when you owe more, you are paying more for interest, and as you pay off your mortgage, you owe less!
The catch: refinance fees
It costs money to do a refinance. The bank will charge you "origination fees", they might charge you appraisal fees, in certain consumer-hostile states there might even be a refinance tax, because the banks successfully bribed your state to make those taxes so that you don't refinance.
These fees can be thousands or 10s of thousands of dollars. But they are the only reason that it might take a year or two to "break even" after refinancing. Just subtract those fees from your savings to see the break-even duration. If that duration is less than a couple years, it's probably a good idea to refinance, unless you expect rates to get even lower in that time (they probably won't right now, IMO).
A note on variable rate mortgages
Variable rate mortgages are not necessarily a bad deal and may very well be a good deal. They don't really change the formula above very much other than that the APR can (and will) change. In the interests of simplicity, I disregarded the effects of a variable rate mortgage, other than to say that most of the content of my post probably still applies.
Final notes
Shop Around! Shop around when looking for banks! Even after you have a "preapproval" letter from your bank when you are first house shopping, you can still shop around even though they say you cannot (a contract isn't a contract until money changes hands!).
From a UK perspective, it always struck me as odd that remortgaging just doesn't seem to be a common thing in the US.
In the UK, it's normal to have a fixed rate guaranteed for only a few years and then when that rate expires (usually going up quite a bit), everyone does the remortgage dance similar to how you might shop around for a new utility provider or phone plan.
Refinancing in the US costs 1000s. Absolutely nobody is doing that righr now because interest rates are stupid high. My mortgage just went up $300 due to property taxes and insurance. The US is a nightmare in every way these days.
When we bought our first house back in 1991, we assumed the existing mortgage at 9% and reduced our offer a bit because the rate wasn't awesome. We had a 6 month close, and we still had to finance the last 30% of the purchase price. During that 6 months we watched in horror as the rates went up to 14%.
We were able to lock in before it hit 14% and the blended mortgage we ended up with was 11%.
Stupid high. Ha!
Here in Canada, amortization periods and mortgage terms are totally different things. Nobody takes a 30 year term. Most common is a 5 year term on a 20, 25 or 30 year amortization schedule.
Some people take 10 year terms when rates are awesome and they want the comfort of knowing what the payment will be for a decade.
Relative rates between terms is driven by what the current and projected rates are. For instance, if current rates are high and the projection is that they will drop in the future, then a 5 year rate might be lower than a 1 year rate. If current rates are low, then the 5 year rate would usually be higher, but how much depends on the projections.
For pretty much the entire period from 2008 to 2020, the rates here in Canada were incredibly low and projections were to stay low. So the spread between a 6 month term and a 5 year term was minimal. People got used to that.
In Canada, every time you renew your mortgage at the end of a term, it's an opportunity to shop around for better rates, pay some more down or fiddle with the amortization period. There might be fees or the need for a new appraisal if you change lenders but none of that if you just renew with the name lender.
We used to take shorter terms, often 6 months and usually no longer than 2 years, and always shaved off at least 6 months extra off the amortization remaining at each renewal. The only time we went longer was in 2007 when I was convinced that inflation was on the rise and would drag the rates up. So we picked a 3 year term and 6 months later the crash came and rates dropped 3% over the next year or so.