" I have a mortgage balance of $80,000 on a 30 year 8% loan that I took out 5 years ago.  I have been adding $1,000 to my monthly payment, which will pay off the loan in another 6 years.  I have enough investments to pay off the entire balance.  Or I can refinance into a 15-year loan at 6.75%. Or I can just keep paying the extra principal on the current loan.  And if I refinance, should I continue with the extra payments?"  

A lot of borrowers are hung up on the relationship between early payment and refinancing.  It is more complicated than I realized when I first fielded the question in 2001, and I recently thought it through again.

Past Prepayments:  Because you made extra payments in the past, your balance is lower today than it would have been otherwise.  That reduces the benefit of refinancing now.  But it is water over the dam, at this point your balance is what it is.  Forget about what you did in the past, $80,000 is large enough to make refinance a viable option now.

Repayment in Full:  Since repayment in full is possible for you, it should be the first option considered.  If it makes sense, there will be no balance left to refinance or make extra payments on.

The repayment decision is an investment decision.  When you repay, you are investing the money to earn a return equal to the mortgage rate.  You have decided that $80,000 you now have invested in stocks, bonds, real estate or collectibles would be better invested in repaying your mortgage.

The mortgage rate you use in making this decision is the refinance rate of 6.75%, not your existing rate of 8%.  Since you will refinance at the lower rate if you don't repay, that rate is what you will save by repaying.

Refinancing and Extra Payments: If you don't repay in full, you need to consider the refinancing and extra payment decisions together. 

Since you are not looking to raise cash, your refinance decision is a cost-minimizing decision.  You must determine whether shifting to the 15-year loan at a significantly lower rate will generate savings in excess of the cost of refinancing.  You can do this using calculator 3a, Refinancing One Mortgage. 

If you refinance to lower your rate from 8% to 6.75%, you reduce the return on extra payments.  This might or might not affect your decision to continue to make such payments. 

If you decide that you will continue to make extra payments in the future, even though the return is reduced to 6.5%, you factor this into your analysis of the benefits of refinancing.  In using the refinance calculator, you do that by shortening the remaining term of your new mortgage.  If you plan to refinance into a 15-year loan, for example, but extra payments would result in payoff in 10 years, you use 10 years as the term.  You can determine the payoff period from any extra payments using my calculator 2a, Effect of Extra Monthly Payments.

Copyright Jack Guttentag 2007