December 13, 2010 in Refinancing

Refinance or pay extra on mortgage?

Dear Dr. Don,

I bought my apartment in Brooklyn in 2003 with a 30-year fixed mortgage rate of 5.25 percent on approximately \$310,000 with monthly payments of about \$1,705. I would like to own my home outright in 15 years, and I am therefore considering refinancing. I think a new 15-year mortgage would add about \$350 per month to my payments. I am reasonably sure I can afford an extra payment of about \$350 per month. But is it worth it, or should I just pay an extra \$350 a month to the current mortgage?

— James Juxtaposer

Dear James,

Seven years in on a 30-year fixed-rate mortgage, you’re right to consider shortening the term of the loan when refinancing. The table below estimates your existing loan balance, and shows the difference between refinancing and just making additional principal payments on the existing loan. You can use Bankrate’s amortization schedule calculator to tighten up these numbers to reflect your exact situation.

The estimated after-tax expense assumes that you can fully utilize the mortgage interest deduction on your taxes and estimates a federal marginal income tax rate of 25 percent.

Existing mortgage Existing mortgage with additional principal payments Refinance 15-year fixed Difference
Loan balance: 274,000.00 274,000.00 274,000.00
Interest rate: 5.25% 5.25% 4.25%
Loan term (months): 276 200 180
Monthly payment: 1,711.84 2,408.50 2,061.24 349.40
Total interest expense (pretax): 198,469.17 137,202.33 97,023.71 (101,445.45)
Estimated after-tax expense (25 percent): 148,851.87 102,901.75 72,767.78 (76,084.09)

The advantage of making additional principal payments is that you don’t have to pay closing costs on a refinancing. The advantage of refinancing is that you’ve locked in a mortgage interest rate about 1 percent below your current rate. For the 15-year fixed-rate mortgage, I used 4.25 percent in the table above because it came the closest to the \$350 difference in payments you mentioned in your letter.

If you’re planning on staying in the apartment long term, then refinancing is the way to go. You sound a little unsure about your ability to make the increased monthly mortgage payment. If that’s true, then consider refinancing into a 20-year mortgage instead of the 15-year and then make additional principal payments on that mortgage. The monthly payment will be about what you’re paying now. That way you’ve captured the lower rate in refinancing, you haven’t extended out past your existing mortgage and you can make additional principal payments when there’s room in your monthly budget.

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