To get savings, is it better to prepay or refinance my mortgage?

Whether you should prepay your mortgage to achieve interest savings or refinance depends on a number of factors -- how far along you are into your existing mortgage, the existing mortgage's interest rate, what's available in the market in terms of a new mortgage and interest rate, how long you expected to be staying in your new loan, and of course, your financial situation.

Start prepaying or refinancing early

The greatest effects on total interest cost from either prepaying or refinancing happen in the early years of your mortgage, when loan balances are highest and remaining terms the longest. By way of example, prepaying a $200,000 30-year fixed-rate loan at 4% with a $100 per month prepayment that begins at the 13th payment will save about $25,000 in interest cost and shave 56 months off of the loan term. Starting that same $100 prepayment with the 61st payment and the savings are pared back to about $18,000, with the term reduction shortened to 45 months.

That's the case with refinancing, too, since at least in most cases, refinancing means re-starting the amortization clock all over again. Refinancing a one-year-old 30-year loan to a new 30-year loan means the total payoff time for your home could be 31 years; refinancing at the 61st payment as above could see you have a total term of 35 years... and the longer you make payments, the harder it is to create savings, even if the new loan's interest rate is lower.

Consider the above, but instead or prepaying, refinancing from a 4% rate to a 3.25% rate. If paid to term, the 4% rate would see you spend $143,739 in interest cost. If refinanced after 1 year, the amount being refinanced (not including any closing costs added in) would be $196,478, and the total interest costs of 1 year on the old loan and 30 years of the new one would be $119,289 -- so your gross savings would be $24,450. Contrast that with a refinance at the 61st month -- the total interest cost of 5 years of the old loan and 30 of the new would total $140,705 -- only about $3,000 less than you would have paid on the existing loan if you hadn't refinanced. As well, closing costs for the new loan would likely have wiped out those meager savings, too.

Can your budget handle prepaying?

When considering prepaying or refinancing, your financial situation comes into play. While prepaying can bring savings, finding extra funds to make additional payments can be a challenge. It's also true that there may be any number of other obligations that could bring greater benefit if you have additional funds to attack them. If you're inclined to prepay your mortgage, and before you start the process, you should learn everything about prepaying your mortgage, as there's a lot more to know and understand than you might think.

So where prepaying your existing mortgage requires additional funds, refinancing may not, since the required monthly payment should decline from both a lower rate and a smaller-than-original loan balance. In fact, in the refinance example above, and if closing costs aren't added to the loan amount, refinancing from a 4% loan after one year (remaining loan balance $196,478) to a 3.25% rate would see the monthly payment fall by $99.75 per month; refinancing after 60 months have passed ($180,895 balance) would see the new payment be over $197 per month lower. In either of these situations, refinancing would create money for prepayment without any impact on your budget, so you could both refinance and prepay your way to savings with little or no impact on your budget.

To determine the best outcome for your situation, you'll need to run some numbers on a mortgage calculator which can handle prepayments from where ever you are in your existing mortgage's amortization term. HSH.com has a downloadable calculator called the Homebuyer's Calculator Suite which allows for this.

Prepay/refi: Time frames matter

Whether or not it's better to refinance or prepay your way to interest savings also depends on how long you remain in any new mortgage you get. This isn't necessarily the same time period as you intend on owning your home, since it's possible you might refinance again at some point in the future (as you are considering doing now). Since its cost free, prepaying can start anytime and will have knowable benefits in terms of how much you've paid down your loan and how much interest you save over a number of time horizons. Refinancing, on the other hand, will depend on how much of a differential in interest rate you can get from your old loan to your new, how you intend to pay the closing costs for the refinance, how long it may take you to recoup those costs, and ultimately how long you remain in the new loan.

Even if the savings are considerable as in the $167 per month differential above, it's very possible for a refinance to cost you money. If the refinance costs $4,000 to complete, you'll need to be in your home 24 months just to recover those costs before any savings actually start, and should you sell your home or refinance again soon after (or before) you'll have lost money or broke even at best. So it can help to have at least a sense of how long you expect to hold the new loan and compare costs and savings over that time horizon. So before you consider refinancing, at a minimum you'll need to know this break-even point, so use HSH's Should I refinance my mortgage? calculator.

Making your own mortgage term

If you have a specific end-date you would like for your mortgage, you can use HSH.com's "It's My Term" prepayment calculator -- you tell us the term, we'll tell you the amount of the prepayment needed to hit the goal, as well as how much interest you'll save.

Back to your question: Use the calculator to run the amortization for your loan. Take a note of how much interest you will pay over the entire term. Then, determine how much additional monthly payment you can send, and add that in starting with the month you desire, and then recalculate. Now re-check the total interest cost for your prepaid loan, and see how much interest you will save, and how much shorter the term will be.

A different method would have you plug in numbers for the loan as though you are refinancing to a new mortgage. Run the amortization as above and determine how much principal remains to be paid and the remaining term and jot them down somewhere. Then, clear out the calculator, and add in the remaining principal from above as the new loan amount, add in new interest rate and new term, and then calculate. You can then compare the total interest cost and term of the refinanced loan below against that from the pre-paid loan above to see what will save you the most money.

Create refinance-like savings via prepayment

When considering refinancing versus prepaying, one factor is that market conditions may not be right for you to refinance. However, and if your budget can handle it, you can create refinance-like savings by prepaying your mortgage. The math can get a little challenging, but HSH has a calculator we call PreFism, our prepayment can be equivalent to refinancing calculator. Plug in your loan info and your prepayment, and the calculator will tell you the effective interest rate you've achieved by prepaying your loan.

Think you would like a loan with a 2% effective interest rate? An offshoot of PreFi is HSH's LowerRate mortgage prepayment calculator, where you specify the effective interest rate you would like your loan to be, and the calculator will tell you the amount of prepayment you'll need to make that happen.

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