Avoid this refinance trap
One of the main reasons we refinance our home loan is to reduce the amount of interest we pay to the bank. The normal process is to calculate the interest we currently pay and compare it with the new loan. Allow for the costs of refinancing, calculate the difference and see if it’s worth doing.
One key item we miss in this calculation is the loan term.
You start with a 30 year term on your current loan.The loan is now 6 years old so there are 24 years to go. You find another loan with an interest rate 0.6% lower than yours. Your calculations show this is worth doing so you refinance your loan.
Your new lender says your loan repayments are now $x/month based on a normal 30 year loan term. You think great my loan repayments are lower and I’m saving interest, I’ll go with that, looks good. More money in my pocket.
Unfortunately you’ve just fallen into a refinance trap. Accepting a new 30 year loan term, increases the time to pay off your loan and increases the total amount of interest you will pay. Yes, you will have more money in your pocket now, but over the long term you loose out.
To avoid this refinance trap, do one of three things:
- Set the loan term with your new lender the same as your current remaining term. In the case above 24 years.
- If you take the 30 year term, keep your repayments at the same level as your current loan.
- Keep the current loan term and repayment amount the same when you switch lenders.
The key take out here is to be clear why you are refinancing and clearly see the long term financial benefit. If you can’t then stay put and avoid this common refinance trap.
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