Many mortgage borrowers view extra payments and refinancing
as alternatives and are confused as to which would serve
them better. This article is directed to them.
Extra Payment Decisions Versus
Refinance Decisions
While borrowers
refinance for several
possible reasons, only those taken to reduce the interest
rate can be viewed as an alternative to making extra
payments. Borrowers should refinance to reduce the rate if
the savings from the rate reduction, over the period the
borrower expects to hold 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 quantify the
savings and costs.
The prepayment decision, in contrast, is best viewed as an
investment decision. The funds used for extra payments are
or could be invested in CDs, bonds or other assets and would
earn the return being paid on those assets. Instead, they
are invested in reduced mortgage debt on which the borrower
earns a return equal to the mortgage rate. Yes, you read
that correctly. If you are paying 5% on a debt and you pay
it off, the funds used for that purpose earn 5%. The
borrower should make extra payments if the mortgage rate
exceeds the rate of return on the assets the borrower would
hold otherwise.
Because they are based on very different factors, extra
payment decisions and refinance decisions should be assessed
independently. Yet each may affect the other, which is why
it is easy to become confused. Two situations arise where
borrowers are seemingly faced with a choice between making
extra payments and refinancing.
Complete Payoff Versus
Refinance
One situation 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. He should pay off the loan if the return
on the assets used to fund the payoff is below the rate on
the mortgage after refinancing. Otherwise, he should
refinance.
Here are some illustrative numbers. The mortgage rate is 4%,
the assets used to fund loan repayment yield 3%, and the
borrower could refinance into a 3.25% mortgage that would be
profitable over 10 years. In this case, the borrower should
pay off the mortgage because the 3% cost is less than the
3.25% rate on the mortgage after refinancing. On the other
hand, if the borrower is earning 4% on the assets used to
fund the loan repayment, he should leave the assets alone
and refinance.
Periodic Extra Payments and
Refinance
The second situation is where a borrower making or planning
to make periodic extra payments, may also have an
opportunity for a profitable refinance. In this case, 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 accordingly. 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. On the other hand, if the
lower refinance rate induces you to terminate the extra
payments, you should use the longer mortgage term in
assessing the refinance.
You can assess whether or not a
refinance would be profitable
HERE.
