Dear Dr. Don,

I am hoping to get some advice on refinancing. My wife and I purchased a home in 2000 for \$190,000. We put \$30,000 down on the purchase.

Ten years later, I owe about \$108,000. This is with making additional monthly payments toward principal. The rate of my current loan is 5.5 percent.

Should I refinance to get maybe 4.5 percent? Or, should I continue my current rates and make additional payments toward principal? According to my current payments, I estimate I can pay off the current balance in seven years.

— Dennis Denouement

Dear Dennis,

By aggressively paying down principal, you’ve put yourselves in a position where you can have the mortgage paid off in seven years, even if you don’t refinance. That’s great.

Because you’re so close to the finish line, the decision to refinance to capture a lower mortgage rate depends greatly on what you’ll pay in closing costs.

I’m assuming you don’t have any need to extend the mortgage to 15, 20 or 30 years and want to pay off the mortgage on roughly the same schedule as your existing mortgage, which you estimate will be in seven years. The following table shows a comparison between your existing mortgage and a new loan at 4.5 percent.

Comparing two mortgages
 Existing mortgage w/additional principal payments Refinance Difference Loan balance: \$108,000 \$108,000 Interest rate: 5.5 percent 4.5 percent Payoff date (years): 7 7 Monthly payment: \$1,551.96 \$1,501.22 \$50.74 Total interest expense (pretax): \$22,365.03 \$18,102.26 \$4,262.77 Estimated after-tax expense (25 percent): \$16,773.77 \$13,576.70 \$3,197.07

That 4.5 percent number seems a bit high for the refinancing. As I write this, Bankrate’s national average for a 15-year fixed rate mortgage is 3.82 percent and the 30-year rate is at 4.42 percent. You can find the most current rates by checking out Bankrate’s Interest Rate Roundup. With your targeted payoff, you can make a good argument for a 7/1 ARM. In any refinancing you’d want to make sure that there’s no prepayment penalty.

Bankrate doesn’t track a 7/1 ARM in its weekly survey, but a 5/1 ARM is reported at 3.6 percent. Bring the interest rate down into the 3.6 percent to 3.82 percent range and you’ve got a more attractive proposition as shown in the next table:

Mortgage with lower interest rate
 Existing mortgage w/additional principal payments Refinance Refinance Loan balance: \$108,000 \$108,000 \$108,000 Interest rate: 5.5 percent 3.82 percent 3.6 percent Payoff date (years): 7 7 7 Monthly payment: \$1,551.96 \$1,467.30 \$1,456.43 Total interest expense (pretax): \$22,365.03 \$15,253.15 \$14,340.00 Estimated after-tax expense (25 percent): \$16,773.77 \$11,439.86 \$10,755.00

The estimated after-tax interest expense assumes a 25 percent marginal federal income tax rate. It also assumes you can fully utilize the mortgage interest deduction, meaning that it’s not just replacing the standard deduction on your income taxes.

Bankrate’s 2010 Closing Costs Survey showed a national average of \$3,741 for a \$200,000 purchase mortgage. You should be able to do better than that, but closing costs will still eat into the potential interest savings from refinancing your mortgage.

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