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Should I refinance or pay extra toward my mortgage?

Craig Berry
The Mortgage Reports contributor

Should I refinance or pay extra principal?

As mortgage interest rates continue to hover in record-low ranges, millions of homeowners are wondering whether it’s the right time to refinance.

Surprisingly, getting a lower rate is only part of the equation. Sometimes, you’d be better off applying the money toward your principal balance instead.

But other times, you just can’t save the same amount of money unless you lower your rate.

What’s the best answer for you? Let’s find out.

Check your refinance rates (Aug 15th, 2020)

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Why refinance right now?

When you refinance, you pay off the existing mortgage loan and replace it with a new one. The property securing the mortgage remains the same; just the interest rate and terms on the new loan change.

You might refinance for a variety of reasons, including to:

  • Reduce your interest expense
  • Lower your payment
  • Shorten your loan term
  • Consolidate debt
  • Change your loan type (i.e. convert that adjustable rate to a fixed rate)
  • Drop your mortgage insurance

The answer to the question, “Should I refinance?” depends on what you hope to accomplish by re-doing your mortgage, and whether refinancing nails that objective.

Verify your refinance eligibility (Aug 15th, 2020)

When refinancing may not be a good idea

Refinancing is a good idea only when it will do what you want it to do.

For instance, if you need to lower your monthly payment by $100 to afford your monthly expenses, and you can get that done with a refinance, it probably makes sense.

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

Refinance or pay off? Use a calculator to decide

The easiest way to tell if refinancing is worth it for you is yo use an online calculator. This lets you tabulate 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.

You can find one such calculator here: Mortgage refinance calculator

Take a look at one example of how a calculator can help you decide between refinancing and paying down your principal.

Suppose that you plan to sell your house and move in four years. You think you want to refinance your three-year-old, 30-year, $300,000 mortgage from its 4.00 percent rate to a 3.75 percent rate, at a cost of $5,400. The mortgage calculator tells you:

  • Your current mortgage payment is $1,432
  • After three years, your remaining balance is $283,496
  • At 3.75 percent, 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 put you $2,544 in the hole

If your objective was mainly to lower your payment, refinancing might make sense.

But 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, 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.

>> Related: How often can you refinance your mortgage?

Choose the right refinance for your goals

Remember, 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.

Take the example above. If your goal was to cut mortgage costs during the four years you plan to stay in your home, a 30-year fixed refinance might be the wrong loan. Suppose that you chose a 5/1 ARM, with a rate fixed for five years, instead.

You’d be able to get that 3.75 percent rate at no cost, so it would cost you $3,243 in lost equity, but you’d pay $5,712 less over four years, so you’d save money and still lower your payment by refinancing.

If you have a government-backed loan — including FHA, VA, and 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.

Making extra payments toward principal

Sometimes, it may just make more sense to use your refinancing dollars to pay down your principal balance.

For instance, you could use the $5,400 in closing costs instead to lower the loan balance to around $278,000. In four years, your remaining balance would be $251,200. That’s over $10,000 lower than it would be if you’d refinanced.

And if you kept your loan for its lifetime, you’d pay it off ten months sooner.

That’s great if your objective is to pay less interest, or repay your loan sooner. But you were trying to reduce your payment. Can you lower your payment without refinancing?

Yes, you can.

Re-amortizing vs. refinancing

Your loan servicer may be willing to re-amortize your mortgage after your principal reduction. This is also called “re-casting” 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 case, your new payment would be $1,405 a month.

Lenders have rules about re-casting. For one, you cannot do it with government-backed loans. And some lenders have minimum principal reductions you must make in order to qualify for re-casting. For instance, $5,000 or ten percent of the loan balance.

There’s a small upfront cost, too. It usually costs about $250 to re-amortize your mortgage.

Refinance or pay extra each month?

One of the easiest ways to answer the question of whether it pays to refinance is based on how long you intend to live in your current home.

Usually, the less time you intend to stay in your home, the less benefit you’ll get from a refinance.

It’s important to note, however, that according to the National Association of Realtors, homeowners are staying in their homes much longer these days.

It’s used to be six to seven years that the average U.S. homeowner would move. Since 2008, however, the average tenure jumped to 10 years. As such, refinance benefits may become more likely.

One other important note, though. With homeowners staying in their homes for longer periods of time, “serial refinancers” tend to pop up more often.

These folks need to make sure they’re making the best financial decisions according to their situations, and not just getting caught up in the “I don’t want to miss out” mindset.

Shop around to get the lowest refinance rates

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 that you’re getting the best deal.

Verify your new rate (Aug 15th, 2020)