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Refinance Mortgage Instead of Prepaying?

Keith Gumbinger

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Prepaying your mortgage can save you money in the long run and free you from debt years sooner. But, should you voluntarily accelerate your mortgage’s amortization?

Unfortunately, even with all the arguments for prepaying your mortgage, most homeowners don't do it, as least not regularly. That $5,000 earmarked for a one-time prepayment gets spent, or the $50-per-month extra payment goes to other expenses.

It's hard to have the committed discipline to attack a mountain of debt with such a small shovel. It takes a discouragingly long time to make a significant dent, and the gratification of having no mortgage to pay is usually years away. If you're one of those people who just can't seem to make it happen, you might consider a bi-weekly payment plan (discussed later). After you overcome the initial inertia and arrange for it, the savings happen automatically.

Refinancing could be better than mortgage prepayment

There may be a better way, however, using a method which actually forces you to send more money each month to your mortgage, and allows your debt to be retired years sooner: refinancing to a shorter-term mortgage.

You might be surprised to learn that the payments on a 15-year fixed rate mortgage (FRM) aren't double that of a comparable 30-year.

Depending upon mortgage interest rates, a 15-year term carries a monthly payment roughly 30% higher than that of its longer cousin, but sending that additional 30% creates tremendous savings. Interest rates for 15-year mortgages can be substantially lower than 30-year loans, so there are interest savings to be had despite potentially higher payments.

Consider this: a $100,000 30-year fixed rate mortgage loan at 4.5% will see you pay back over $82,405 in interest over 360 monthly payments. Your monthly principal and interest payment is $506.69.

A $100,000 15-year fixed rate mortgage at 4% allows you to pay back only $33,144 in interest over 180 monthly payments. Your monthly payment is $233 higher than the 30-year term, but creates about $50,000 in interest savings... and you have no mortgage after only 15 years.

The savings are even more impressive if you refinance from a higher interest rate. Assume you have a 6%, 30-year fixed rate mortgage with a $100,000 balance. You're scheduled to pay $600 per month, with total interest charges of $115,838 over the entire term, and you've been in your home for one year. You decide to refinance, with an outstanding balance of $98,772.

You choose a 15-year fixed rate mortgage at 4%. Your monthly payment rises to $731 per month (an increase of about 22%), but over the term of the loan, you are scheduled to pay only $32,737 in interest. Subtracting the interest you've already paid in first year ($5,967), and assuming 2% costs to refinance ($1,975), your net interest savings are over $75,000.

In effect, for an additional $131 per month, you are mortgage free in a total of just 16 years. If your income has risen, but your savings haven't, or you can't seem to find funds to prepay your mortgage on a regular basis, consider refinancing to a shorter term. For you, it would be a forced (rather than voluntary) mortgage prepayment plan.

If the change to a 15-year term brings a monthly payment that is too high (or if you can't qualify), consider a 20-year term. The increase in the monthly payment should be less, but you still chop nine years off your loan, so some significant savings can be enjoyed.

You can compare multiple mortgages at the same time with our mortgage calculator.

Refinance mortgage with same payment, shorter term

Given the right intersection of time and interest rate differential, it is possible to swap to a 15-year FRM with no change in the monthly payment at all. As an example, you have a $100,000 30-year FRM at 5%; the payment is $536.82 per month. To keep this same monthly payment with a new 15-year FRM at 4%, the remaining balance will need to be $72,574; which should be the remaining balance on your 30-year loan at about the 161st payment.

After about 13 years into your original mortgage, you will have paid $58,924 in interest out of a total due of $93,256 in total interest cost, so there would still be $34,962 in interest to be paid. You refinance to a new 15-year FRM at 4%, instantly chopping 19 months off the time left in your original loan, resulting in a total remaining interest cost of $24,034. You just saved nearly $11,000 in interest expense (some of those savings may be lost to closing costs for the new mortgage, though). A refinance calculator can help you determine whether or not to change your existing mortgage and how to cover the costs of a refinace.

Want savings, but can't or don't want to refinance your mortgage?

With interest rates moving away from about 60-year lows around 2016, it's reasonable for homeowners to balk at refinancing. Trading a lower interest rate for a higher one has no appeal and changing mortgage underwriting standards or to your own income and debt profile can mean you may not be in a position to refinance.

There is a way to prepay your mortgage and achieve savings equivalent to an actual refinance, without the hassle and expense. Consider a concept HSH developed, where "mortgage prepayment is equivalent to a refinance" (Prepayment::Refinance), and let the HSH-engineered Prepayment::Refinance ("PreFi") Calculator do the complex math for you.

There are a few concepts to grasp as you begin:

  • Very often, a refinance is done to lower the mortgage's interest rate and monthly payment. This usually results in long-term interest savings.
  • For fixed-rate mortgages, increasing your monthly payment above what is required (prepaying) also results in lower total interest cost for the mortgage.

    As an example, let's say you have a $100,000 30-year fixed-rate mortgage with a 4% interest rate. You have made 12 monthly payments.

    If you make no prepayments, you have 29 years remaining on your loan and will pay total interest charges over that time of $67,903.52.

  • You would like to refinance, but today's 15-year fixed rates are close to 4.25% and the combination of shorter terms and higher interest rate means increasing monthly payments quite a bit, so it's just not worth it even if you can qualify for the new mortgage.
  • You can, however, send in an extra $100 per month. Starting with the 13th payment, you do so and continue until the loan is retired. By your action, your remaining loan term has been shortened to just 21 years, and the total interest you have paid is $47,043.91.

The total interest you paid is equivalent to having refinanced your $98,238.98 mortgage for a new 29 years at an interest rate of 2.907%; this is the "effective interest rate" you have engineered for your mortgage rather than the 4% contract interest rate for which you signed on. You have achieved savings equivalent to refinancing by prepaying your mortgage.

Creating a better effective mortgage interest rate or term by prepaying

Perhaps you are lamenting the fact that you have a 4.5% interest rate on your existing mortgage loan, and missed the chance to refinance when rates were at 3.75%. Mathematically, it's possible to prepay your mortgage to achieve an effective interest rate you want.

Using the above $100,000 30-year loan, but with a 4.5% interest rate, and assuming you made the same 12 monthly payments, how much additional monthly payment would you need to make to have an effective 3.75% interest rate? The amortization can be pretty complicated, but that's where our unique LowerRate Prepayment Calculator comes in. Starting with the 13th monthly payment, a monthly prepayment of just $50.54 is enough to make the interest paid over the remaining 29-year term equivalent to having a 3.75% interest rate.

Perhaps you want to prepay your loan to produce a mortgage with a 20-year term at 3.75% -- generating the same interest savings as though you had refinanced to this rate and term? Send in an extra $193.73 per month and it happens.

The math may be complicated and the concept a challenge to grasp, but the savings, interest rate or term you are after may be pretty easy to attain.

Having reviewed our previous article Choices other than prepaying your mortgage and assessed whether or not refinancing could be a good solution, be sure to read our next article: Before prepaying, review your mortgage contract.

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