Should I refinance or just pay down the principal?

Craig Berry
The Mortgage Reports contributor

“Should I refinance?” Good question

As mortgage interest rates continue to hover in record-low ranges, millions of homeowners continue to wonder, “Should I refinance my mortgage?”

Surprisingly, the availability of 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.

Shop refinance rates with top lenders here. (Aug 20th, 2019)

Why refinance?

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.

Related: When does refinancing make sense?

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.

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.

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

But if you’re trying to reduce your overall mortgage expense, and refinancing adds to that cost, you should probably pass. Our mortgage calculator with amortization schedule can help you figure this out.

Use a mortgage calculator to decide

For instance, 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.

Related: How often can you refinance your mortgage?

  • In four years, your refinanced loan balance will be $261,421.
  • Had you not refinanced your mortgage, in four years, your balance would be $258,178. And you would not have spent $5,400 on refinancing. So your refinancing costs are $8,643.
  • You would get an extra $119 a month in your pocket each month, or $5,712 over four years.

If your objective was mainly to lower your payment, refinancing might make sense, but not if you’re trying to cut your financing costs. You would have spent $8,643 to save $5,712 over four years.

Choose the right refinance for your objective

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.

Related: Refinance without “starting over” at 30 years

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.

Paying down your principal balance

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.

Which is 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.

Verify your refinance eligibility (Aug 20th, 2019)

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.

Related: 9 ways to lower your mortgage payment

Lenders have rules about re-casting. For one, you can’t 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. It usually costs about $250 to re-amortize your mortgage.

Refinance or pay more 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.

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 even lower mortgage rates

Today’s mortgage rates are so low that refinancing might make sense for you now, even if it did not a year ago. For one thing, your plans may have changed, and you might be able to consider a 5/1 ARM or 15-year fixed with lower a interest rate.

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

Shop top refinance lenders here. (Aug 20th, 2019)