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.
