Dear Dr. Don,

My wife and I are trying to figure out if it’s a smart move to refinance our current loan — we just finished paying off the first year — and go from a 30-year fixed-rate mortgage to a 20-year fixed-rate mortgage.

I used Bankrate.com’s mortgage calculator to check how much interest overall we would save. I don’t know if it is better to use the money we spend on the origination fees and settlement fees or to put that money directly toward the current mortgage principal. Here are the numbers:

Current loan

  • 30-year fixed-rate loan of $317,400 at 5.375 percent.
  • Paying $1,777.35 a month plus $479.79 for escrow.

We’ve paid off one year of the original loan to a loan balance of $312,649.24. I had put down 25 percent when I bought the house for $423,000.

New loan

  • 20-year fixed-rate loan for what I assume will be $312,649.24 at 4.375 percent.
  • Pay $1,956.94 a month plus $479.79 for escrow.

I will also have to put down $7,500 for closing costs.

Added bonus: We were also thinking of putting another $30,000 toward the principal since this money is currently in a money market account and not earning very much. Should we put this money toward the new loan or the old loan? Any insight would be greatly appreciated.

— Bryan Bifurcate

Dear Bryan,

I ran the numbers for you, too. At $7,500, I think your closing costs are a little high. Bankrate’s 2010 Closing Costs Study has the national average for closing on a $200,000 purchase mortgage at $3,741. Have your lender walk you through the projected costs.

Mortgage rates are lower now than the rates you provided, but I’ve used your 20-year rate for the illustration below:

20-year rate expense
Existing mortgage Refi with a

20-year mortgage

Loan amount: $312,649 $312,649
Interest rate: 5.375 percent 4.375 percent
Loan term (months): 347 240
Mortgage payment: $1,777.34 $1,956.94
Total payments: $616,738 $469,666
Total interest: $304,089 $157,016
Effective interest expense1: $228,067 $117,762
1 Assumes 25 percent marginal federal income tax rate and no state income tax impact.

Saving 1 percent on the interest rate and shortening the loan term to 20 years cuts your interest expense in half. The effective interest expense assumes you can fully utilize the mortgage interest deduction on your federal income taxes.

I also ran the numbers for your additional payment scenario. The additional principal payment is larger for the existing mortgage by $7,500 because you don’t have to pay any closing costs. You would want to make sure there isn’t a prepayment penalty before making that big of an additional principal payment on the existing loan.

Additional payment expenses
Existing mortgage

w/additional principal

of $37,500

20-year refi

w/additional principal

of $30,000

Loan amount: $275,149 $282,649
Interest rate: 5.375 percent 4.375 percent
Loan term (months): 265 240
Mortgage payment: $1,777.35 $1,769.16
Total payments: $470,722 $440,599
Total interest: $195,573 $141,950
Effective interest expense1: $146,680 $106,462
1 Assumes 25 percent marginal federal income tax rate and no state income tax impact.

As you can see, there’s a $40,000 difference, after-tax, in interest expense by refinancing, plus making the additional principal payment. You’d want to make sure you’re not emptying out your emergency fund to make the additional principal payment.

My rule of thumb with additional principal payments is to go ahead and make them if you expect to earn less after-tax on your investments than the effective rate on your mortgage. You can use Bankrate’s mortgage tax deduction calculator to estimate the effective rate on your mortgage, again assuming you can fully utilize the mortgage interest deduction.

Even with the high closing costs, I’d go with the refi — presuming you plan to be in the house long enough to justify those closing costs.

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