Does prepaying mortgage trump refinance?

Don TaylorQuestionDear Dr. Don,
Doesn't prepaying a mortgage accomplish the same result (i.e., reducing the term and the "effective" interest rate) as refinancing? The advantage to prepaying versus refinancing is there are no closing costs. Are there any advantages to refinancing? My wife and I were thinking about refinancing, but now I'm not so sure.
-- Randy Refi

AnswerDear Randy,
Making additional principal payments on a mortgage reduces its term and the total interest expense, but doesn't reduce the effective mortgage rate. In some instances, it will actually raise the effective interest rate.

For example, if you paid discount points at closing, having these points spread over a shorter loan term will increase your effective interest rate.

There's a difference between the annual percentage rate calculation and the effective interest rate on your loan. One primary difference is that the effective interest rate considers any impact your interest expense has on your personal income taxes.

You can use Bankrate's mortgage tax deduction calculator to demonstrate this point. Put in an initial interest rate, loan term, federal and state marginal income tax rates, and closing costs. Then, calculate the APR and APR after tax, which serves as a proxy for the effective rate.

Finally, change only the loan term by shortening it by a few years and have the calculator determine the two interest rates.

The advantage of refinancing is in getting a lower interest rate, which reduces your total interest expense. The disadvantage is in paying closing costs on the new loan. But if you're 10 years in on a 30-year mortgage, refinancing into a new 30-year mortgage may raise your total interest expense because you've extended the loan term.

Bankrate's refinance interest savings calculator provides you with an estimate of the pretax savings from refinancing.

If you plan to stay in the house for a while, it's hard to argue against refinancing at these historic low rates -- presuming you have a good credit history and enough equity in your home to get refinanced.

Bankrate has an entire channel on its website dedicated to refinancing your home. Spending a little time there reading articles on refinancing could help you gain the confidence that a refi is the right decision.

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