refinance

Prepay mortgage or refinance your home?

Don TaylorQuestionDear Dr. Don,
My wife and I have a mortgage balance of about $60,000. Our principal and interest expense is about $1,000 per month. We're about eight years into a 15-year mortgage. I was told that if we made a lump-sum additional principal payment of either $10,000 or $20,000, we would pay off our mortgage earlier and our monthly interest payment would go down quite a bit. At the same time, our monthly principal payment would go up quite a bit, so we would be paying much less in interest on the remainder of the mortgage. Is there any truth to that?
-- Terry Term

AnswerDear Terry,
It's all true. When you make an additional principal payment, you reduce the outstanding mortgage balance. The interest component of your monthly mortgage payment is based on the loan balance. A lower loan balance means a lower monthly interest expense.

On an amortized, fixed-rate mortgage, the loan payment is contractual and doesn't change. An amortized loan has a monthly payment large enough to cover last month's interest expense and to pay down a part of the principal balance. As the loan balance declines over time, more of your monthly payment goes toward the repayment of principal.

Because the loan payment doesn't change after you make an additional principal payment, what does change is the life of the loan. You will repay the loan faster than the stated loan term. You can use Bankrate's mortgage calculator to determine how a lump sum payment reduces your mortgage interest expense and the remaining loan term.

I'm a little concerned about your numbers. I'm hoping your principal-and-interest payment is actually the principal, interest, taxes and insurance, or PITI, payment. If you have a $1,000 mortgage payment with seven years left on a 15-year mortgage and a current loan balance of $60,000, your mortgage interest rate is roughly 10.25 percent. If that's the case and your credit scores can handle it, you'd be better off splitting that lump-sum payment between closing costs on a refinancing and reducing the loan amount.

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