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:

1. 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.
2. 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.
3. 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:

1. 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!
2. 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!).