Should I refinance my VA loan?

Dear Dr. Don,
I have a VA loan at 7 percent, with $127,000 and 26 years remaining on the loan. Would it make more sense to pay a lump sum of $30,000 on my present loan or refinance at a lower interest rate and borrow $30,000 less?
-- Gary Grands

Dear Gary,
Take a step back and look at the big picture. Will you still have an emergency fund if you pay down the loan balance? What are your financial goals? Do you have a retirement fund? If the $30,000 represents most of your savings and investments, then you shouldn't spend it down just to have a smaller monthly nut on your mortgage.

I used Bankrate's Mortgage Calculator to estimate your current mortgage payment, and what would happen with your existing mortgage if you made a one-time lump-sum payment of $30,000. Then I contrasted prepaying your existing mortgage with refinancing the loan as a 15-year mortgage. I chose a 15-year mortgage because it approximated the number of months that it would take you to pay off the 7-percent current mortgage if you made a $30,000 lump-sum principal prepayment. The results are shown below:

You can save a lot of interest expense by refinancing with a 15-year fixed-rate mortgage and it will still free up $100 a month in your budget. I didn't consider the reduced-income tax deduction or the closing costs associated with the new mortgage. I also didn't look at the potential return from investing the $30,000 elsewhere, or using the freed-up $100 a month to make additional principal payments on the 15-year mortgage. Do that and you can reduce your total interest expense to $36,220 and have your loan paid off in 12½ years.

In general, if you can expect to make more on an after-tax basis on investing than the after-tax cost of debt on your mortgage, then you should invest instead of paying down your mortgage. If you like the certainty of the reduced interest expense and having your loan paid off sooner, that can outweigh the investment option.