Some of the most difficult questions I receive from readers concern the relationship between making extra mortgage payments (prepayments) and refinancing. I have never been very happy with my answers, and recently took a harder look at how making extra payments and refinancing are related. The hope was that if I understood it better, I could answer the questions better. This article reflects my current understanding, followed by new answers to some common questions.
Prepayment Decisions Versus Refinance Decisions
Borrowers refinance for several reasons: to reduce the rate, reduce payments, reduce risk of future rate increases, and raise cash. Only rate reduction refinances may be related to or compared with a prepayment decision.
The decision to refinance in order to reduce rates involves a judgment that the savings from the rate reduction, over the period the borrower holds the new loan, will more than cover the refinance costs. The three must important factors in this judgment are the size of the rate reduction, the refinance costs as a percent of the balance, and the life of the new loan. Mortgage Refinance Calculator 3a pulls these and other factors together to generate an answer.
The prepayment decision, in contrast, is best viewed as an investment decision. The funds used for extra payments could be invested in CDs or bonds where they would earn the return being paid on those assets. Instead, they are invested in reduced mortgage debt on which they earn a return equal to the mortgage rate.
Because they are based on very different factors, extra payment decisions and refinance decisions should be made independently. Yet each may affect the other, which is why it is easy to become confused.
Payoff Versus Refinance
The simplest case is where the borrower has a sizeable amount of assets that could be used to pay off the mortgage in full, and also has an opportunity to lower mortgage financing cost by refinancing. It is simple because he does one or the other. He should make the investment decision first, based not on his current mortgage rate but on the rate he could get if he refinanced. He refinances only if he has made the prior decision not to pay off the mortgage.
Periodic Extra Payments and Refinance
Periodic extra payments and refinance are not mutually exclusive, the borrower can do both, but they may affect each other. A rate-lowering refinance reduces the rate of return on future extra payments, which could induce the borrower to reduce or stop such payments. However, the principal motivation for making extra payments seems to be to get out of debt faster, and the refinance won’t change that.
Extra payments made in the past don't affect the refinance decision to be made now, though such payments would have made today's loan balance smaller, which reduces the benefit from a refinance.
Extra payments that borrowers expect to make in the future should be factored directly into the refinance decision process. Extra payments reduce the expected life of the loan, which (other things the same) reduces the benefit from the refinance. In using the refinance calculator, you should shorten the term of the new mortgage. If you plan to refinance into a 30-year loan, for example, but extra payments would result in payoff in 20 years, you should use 20 years as the term.
Questions on Prepayments and Refinancing
Here are the three questions I receive most often:
“I have been making extra payments on my mortgage consistently. If I expect to refinance in the near future, should I continue with the extra payments?”
There is no reason not to. The benefit from the extra payments you are currently making, consisting of the balance reduction, is not affected by a subsequent refinance. After the refinance, the return on additional extra payments will be lower because of the rate reduction. This might cause you to reduce the payments, but probably won’t for reasons indicated earlier.
“I am trying to decide whether to refinance into a lower rate, or pay off my entire loan balance…”
Make the investment decision first, based on the rate expected in a profitable refinance. If it is a good investment at that rate, do it. If the investment decision is negative, then refinance.
“Am I better off making extra payments on my existing loan, or refinancing it?”
These should not be viewed as alternatives. Make the refinance decision first, if it pays to refinance, do it. Consider whether you want to make extra payments after you refinance, or if you don’t refinance.