Some of the most difficult questions I
receive from readers concern the relationship between making extra
payments 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.
Extra payment decisions and refinance
decisions should be made independently because they are based on very
different factors. Yet each may affect the other, which is why it is
easy to become confused.
The extra payment decision 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.
What mortgage rate? The rate the borrower
would have paid on the balance they pay off, which is their current
mortgage rate. In principle, if they anticipate that they will refinance
to a lower rate, then that lower rate is the one that will be earned on
the extra payments, but that won’t apply until after the refinance, when
the extra payment decision could be reconsidered.
It
is very doubtful, however, that a rate-lowering refinance induces many
borrowers who have been making extra payments to reduce them. The
principal motivation for making extra payments seems to be to get out of
debt faster, and the refinance won’t change that.
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
affected by extra payments.
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. Calculator 3a on
my web site pulls these and other factors together to generate an
answer.
How can extra payments affect the
refinance decision? Those made in the past don’t figure directly in
current decisions. However, past payments have reduced the loan balance,
which reduced the benefit from a subsequent refinance. As balances
become smaller, the benefit from refinancing shrinks and at some point
disappears. Indeed, few lenders are interested in refinancing loan
balances of less than $50,000.
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.
Here are three questions I receive quite
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…”
These should not be viewed as
alternatives. Make the investment decision first, based on the rate
expected in a refinance. If it is a good investment at that rate, do it.
If the investment decision is negative, then assess the profitability of
a 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.