Should I refinance or pay extra toward my mortgage?

Craig Berry
The Mortgage Reports contributor

Should I refinance or just pay extra?

With mortgage interest rates near record lows, refinancing your current mortgage might seem like a no-brainer. Millions of homeowners could lower their monthly payments and save on long-term interest.

But what if you already have an ultra-low rate? Or you’re nearly done paying off your home loan?

In some cases, starting your mortgage over with a refinance won’t make sense. Luckily, you can still save on interest — and potentially pay off your home early — by paying extra toward your mortgage.

Here’s how to choose the right strategy.

Verify your refinance eligibility. Start here (Oct 17th, 2021)

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Refinance or pay extra: An overview

Knowing when to refinance — or when to keep your existing loan and make additional payments — depends on your financial goals and specific needs.

Everybody’s situation is a little different, but here’s a quick way to assess your own scenario:

It’s usually better to refinance when:

  • You expect to stay in the home a long time. The upfront costs of refinancing pay off when you stay in the home long enough to benefit from the new loan’s savings
  • You’re not far into the existing loan. If you’ve only had your existing mortgage a few years, you’re more likely to save money in the long run by refinancing
  • You also want to tap home equity. With a cash-out refinance you can save on interest and get cash back to renovate your home, consolidate credit card debt, or use for any other purpose
  • You can qualify for a low rate. Unless you’re doing a Streamline Refinance, your mortgage lender will check your credit score and debt-to-income ratio to determine your rate. Borrowers with great credit, low debt levels, and plenty of home equity have access to some of the best rates and biggest refinance savings

If one or more of these conditions is true for you, you’re probably a good candidate to refinance and pay less interest at today’s historically low rates.

It’s usually better to make extra payments when:

  • You plan to sell the home soon. You could waste time and money refinancing if you sell the home within a couple years. Consider making extra payments on your mortgage principal balance to lower your loan amount instead
  • You’re well into a 30-year loan. If you’re a decade or more into a 30-year loan, you’ve already paid off a big chunk of the loan’s total interest. Starting your amortization schedule over with a new loan could increase your total cost — even if the monthly payments are lower
  • You can’t get a competitive rate. Today’s best refinance rates go to borrowers with higher credit scores and lower debt loads. If this isn’t you, consider making additional payments on your existing loan rather than refinancing, at least until you improve your credit profile

If one or more of these conditions describes your situation, making extra loan payments might offer a better — and more cost-effective — path forward.

If you’re still not sure where you stand, read on. We’ll dig deeper into the details of refinancing vs. making extra mortgage payments.

Check your refinance savings. Start here (Oct 17th, 2021)

Benefits of refinancing

Historically low interest rates during the coronavirus pandemic have prompted millions of homeowners to refinance.

But there’s more to refinancing than just the interest rate.

Refinancing offers a chance to start over. You’ll be getting a new loan to pay off your existing mortgage. And along with lowering your rate, a new loan gives you a chance to improve your financial situation.

For example, a new mortgage could:

  • Reduce your total interest cost over the life of the loan
  • Lower your monthly mortgage payment
  • Shorten your mortgage term
  • Generate cash back from your equity to consolidate debt
  • Replace an adjustable-rate mortgage with a fixed-rate loan
  • Change loan types so you can remove mortgage insurance

Many banks use interest rates to market their loans. As a result, borrowers tend to measure a loan’s savings only in terms of interest.

But even if you don’t save big on your interest rate, a refinance loan could help you accomplish any of the financial goals above.  

Drawbacks of refinancing

Refinancing is a good idea only when your new loan will benefit you in the long run. 

For instance, if you need to lower your monthly payment by $200 to afford your monthly expenses, and you can get that done with a refinance, the new loan probably makes sense.

But if you’re trying to reduce your overall mortgage expense, and refinancing adds to that cost, you should probably pass.

Even with a lower rate, your new loan could add to your overall mortgage expense if you:

  • Stretch out your payments too long. Time is a key ingredient in interest payments. Starting over with a new 30-year loan adds a lot of time to this equation
  • Take cash out for shorter-term goals. Borrowing against your home equity makes the most sense when you’re paying for long-term needs like tuition or home improvements. It’s likely not wise to cash-out for short-term needs like vacations or living expenses
  • Think you’ll move soon. It will take time for your refinance savings to ‘break even’ with the upfront cost of refinancing. Selling the home and paying off your mortgage early could prevent you from ever realizing your new loan’s savings potential

Is a lower interest rate enough to make refinancing worth it despite these obstacles? That will depend on your financial situation.

You can use a refinance calculator to estimate your savings or talk to a loan officer for an exact answer.  

Check your refinance savings. Start here (Oct 17th, 2021)

How extra mortgage payments work

Sometimes, it makes more sense to pay down the principal balance on your existing loan instead of getting a new loan.

Also known as ‘accelerated payments,’ this strategy involves paying a lump sum toward your mortgage principal balance.

By doing so, you lower the outstanding loan amount — and therefore reduce the balance you’re paying interest on. This can lower your total mortgage cost and even help you pay off your home early.

There are a few ways you can pay extra on your mortgage. Popular strategies include:

  • Making one extra payment each year. If you can make 13 payments instead of 12 every year, you could shave a few years off your loan term. You could turn your tax return or holiday bonus into a mortgage payment
  • Paying your mortgage bi-weekly. This allows you to make an extra payment each year without making a full payment all at once. Essentially, you’d pay half your monthly loan payment every other week rather than making the full payment once a month, which results in 13 total payments each year
  • Making larger payments. You could add $100 or $200 a month to your monthly payment. The key is to do this regularly so you’ll see long-term savings, and you’ll also need to make sure the extra money goes toward your principal (not interest)

These are good ways to save on interest and repay your loan sooner. But these strategies won’t lower your monthly payment the way a refinance can.

Another option: Recast your mortgage

Your loan servicer may be willing to re-amortize your mortgage after you pay a lump sum toward your principal. This is also called “recasting” your home loan. 

The lender takes your principal reduction and then re-calculates your payment based on the remaining years of your home loan and the remaining balance. 

In this way, recasting your mortgage can lower your monthly payments without the upfront cost of a refinance. But note: your interest rate will stay the same.

Lenders have rules about recasting. For one, you cannot do it with government-backed loans (FHA, VA, or USDA). And some lenders have minimum principal reductions you must make in order to qualify for a mortgage recast. For instance, you might need to pay $5,000 or 10% of the mortgage loan balance. 

There’s typically a small upfront cost, too. It often costs around $250 to re-amortize your mortgage. (Of course, that’s very little compared to refinance closing costs, which are usually 2-5% of the loan amount).

Refinance or make extra payments? Use a calculator to decide

The easiest way to tell if refinancing is worth it for you is to use an online mortgage refinance calculator.

This lets you model your potential savings versus the expected cost of refinancing. That way, you can see when you’d break even and how much you’d save in the long run. 

Let’s take a look at one example.

Suppose you plan to sell your house and move in four years. In the meantime, you’re trying to decide whether you should refinance or make extra principal payments to save money. Assume that:

  • You’ve had the loan 3 years
  • It’s a 30-year fixed-rate mortgage
  • Your current interest rate is 4.0%
  • You could refinance to a rate of 3.75%
  • Your refinance closing costs would be $5,400

First, calculate how much you could save each month by refinancing. The mortgage calculator tells you:

  • Your current mortgage payment is $1,432
  • After three years, your remaining balance is $283,496
  • At 3.75%, your new payment is $1,313, which is $119 less than your current payment

However, you must always consider the cost of refinancing when deciding if it makes sense.

  • Say you spent $5,400 on refinance closing costs
  • You save $119 a month on payments, or $5,712 over four years
  • If you still want to move in four years, your savings will have just canceled out what you spent to refinance
  • But if you decide to move earlier — say, in two years — you will have only saved $2,856
  • In that case, your refinance cost you $2,544 more than it saved you

If you won’t stay in the home long enough to break even, or you want to avoid the out-of-pocket closing costs, refinancing might not be your best bet.

You might also want to avoid a refinance if you’ve had your mortgage for a long time. 

Remember that refinancing starts your loan over at day one. If you’re 15 years into a 30-year mortgage, starting over for a new 30-year term might not be particularly attractive. 

In this case, paying extra might make more sense than pursuing a refinance.

Explore all your refinance options

Keep in mind that a conventional 30-year refinance is not your only option. There are various types of refinance loans, and one might fit your needs better than another. 

For example, refinancing from a 30-year to a 15-year mortgage saves a lot in long-term interest payments.

But keep in mind that a 15-year loan also requires a higher monthly payment. If you’re not sure about committing to those higher payments, making extra principal payments when you could be an ideal compromise.

Another option is refinancing to a different type of loan.

For instance, if you currently have an FHA loan — but your credit score is above 620 and you’ve built up 20% home equity — you could likely refinance to a conventional loan with no PMI. This could get you a lower interest rate and reduce your monthly payment by eliminating mortgage insurance payments.  

If you have a government-backed loan (FHA, VA, or USDA) you should also consider the possibility of a Streamline Refinance

Streamline refinances have less paperwork, so the process is usually smoother and faster. And you might have reduced closing costs as well. 

Shop around to get the lowest refinance rates

If you decide to refinance, be sure to maximize your savings by comparison shopping.

Interest rates can vary by half a percent (0.50%) or more between lenders — which equates to a major difference in your monthly payments and long-term cost.  

Today’s mortgage rates are so low that refinancing might make sense for you now, even if it did not a year ago.

Check with several competing lenders to make sure you’re getting the best deal.

Verify your new rate (Oct 17th, 2021)