Published on May 18, 2008

Mortgage refinance or prepay?

If you have a 30 year mortgage you may think about refinancing for a shorter term loan. But is refinancing the best thing to do with the extra cash you have?

Refinancing has the advantage that once you are done with comparing several offers (hopefully you do so), gone through the approval process and all the paper work, you are in cruise control mode, "only" having to ensure that the automatic payments flow as expected. You pay less interest, build up equity faster and fully own the house sooner. The downside is that you are locked-in with that higher monthly payment and smaller tax deductions (see http://www.irs.gov/pub/irs-pdf/p936.pdf for exact details on deductions).

Let's take an example to back up those statements with some math: you pay 20% down of the house price to avoid PMI (private mortgage insurance) and get a loan for $250,000, including the closing costs, at 5.75% annual interest rate. The monthly payment comes at $1,458.93, not including the escrow (property taxes and homeowner insurance). When you finish paying off the loan, 360 months later, the total out of pocket, excluding the escrow, would have been $275,215.57 (interest) plus $250,000 (principal), a total of $525,215,57.

But after few years, you want to know if you should refinance for a shorter term loan, or stay with the current plan and make an additional monthly payment towards the principal (also known as mortgage acceleration). Which is better?

Let's say that you already made 72 payments and want to refinance with a 15 year mortgage at 5.65% annual interest. At this point the balance is $227,621.10. Add $5,000 in closing costs and the new loan amount is $232,621.10.

The monthly payment will increase to $1,919.28, but overall, the total interest is reduced by $79,702.91. If your total tax is 35% (state, local and federal), the smaller interest means also that your tax deductions will be smaller, which translates to $27,896.02 more in taxes by the time the loan is repaid in full.

If instead you choose to keep the existing loan and pay every month extra $500 towards the principal, the total interest is reduced by $86,727.08, but you will pay $30,354.48 more in taxes. The prepayment option has the additional advantage that is more flexible, as you can stop the additional payments anytime and divert the funds where needed.

In conclusion, in this example the prepay alternative saves more than refinancing. To see what happens in your specific case see the mortgage refinance/prepayment calculator here and plug in your numbers.

Disclaimer:
The mortgage refinance and prepayment calculator is designed for comparative purposes only. This website (tititudorancea.com) does not guarantee the accuracy of any information provided by this calculator and is not responsible for any errors, omissions, or misrepresentations.
This calculator does not have the ability to pre-qualify you for any loan program. Additional fees such as home owner association dues, PMI, homeowner insurance and property taxes are not included in calculations. All information such as interest rates, taxes, etc., are estimates and should be used for comparison purposes only. This website (tititudorancea.com) does not guarantee any of the information obtained by this calculator. For interest tax deductions in your particular situation consult you tax accountant.