Does per diem interest affect refinance?

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Dear Dr. Don,
I’m considering refinancing into a 15-year fixed-rate loan. I currently have a 30-year loan that was refinanced in 2005 for $120,000 at a rate of 5.375 percent. I’ve been making additional principal payments every month and the current balance is $95,000. My lender said it will refinance my loan into a 15-year mortgage at a rate of 4.375 percent with no closing costs. It claims the only charge I would be subjected to is prepaid interest on the current loan payoff. Does this make sense to you? Should I go for it or stick with my current loan and continue sending extra payments every month? The new loan would result in a slightly higher principal and interest payment every month, but the term is shorter.
— Gail Grist

Dear Gail,
The per diem interest expense can affect the old loan and the new loan. It’s just the interest expense not captured by the scheduled monthly payments. If you close on the fifth of the month, you’ll owe five days per diem interest on the old loan and the balance of days in the month in per diem interest on the new loan.

While per diem interest does increase the amount of money you need to bring to closing, it shouldn’t influence the decision whether to refinance. One way or another you’re paying interest on the outstanding mortgage balance.

What you want to manage is the amount of time you could be paying interest on the old and the new loan. To that end, Jack Guttentag, The Mortgage Professor, recommends that you not close on a refinancing on a Friday. His article, “Mortgage Closing Date: Does it Matter?” is a primer for people closing on a new home or refinancing an existing mortgage.

Per diem interest is something different from prepaid interest, or discount points, paid at closing. Discount points reduce the stated interest rate on your mortgage by prepaying part of the interest expense. The points do go into calculating the loan’s annual percentage rate, or APR. The Bankrate feature, “Mortgage points,” explains discount points in greater depth.

If your only expense at closing is per diem interest and you can reduce your loan rate by 1 percent as well as shorten your loan term to 15 years, it’s likely that refinancing makes sense — even though you’ve already shortened your loan term by quite a bit by making the additional principal payments on your existing loan and the loan term will continue to shorten if you continue to make the additional principal payments.

I did a little back-of-the-envelope calculating from the information you provided. It’s shown below. It won’t precisely match your situation, but you can use Bankrate’s mortgage calculator along with its amortization schedule to fit your exact situation.

Refinancing a 30-year loan
Original loan + add’l principal payments Refi
Original loan amount: $120,000.00 $95,000.00
Interest rate: 5.375% 4.375%
Loan term at closing (months): 360 180
Payment: $671.97 $720.69
Additional principal: $150.00 $101.28
Total monthly payment: $821.97 $821.97
Total payments: $195,154.68 $123,569.83
Total interest: $75,154.68 $28,569.83
Loan payoff date: 12/19/2024 10/19/2023
$35,932.15 Interest expense on old loan up to refinancing date.
$64,501.98 Total interest expense.
$10,652.70 Pretax advantage to refinancing.
$7,989.52 After-tax advantage to refinancing at 25% federal rate.

Again, my numbers are guesstimates based on the information you provided. I estimated that the additional principal payments averaged $150 per month because that brought the mortgage balance down to about $95,000 after six years. I also assumed you would keep making these additional principal payments if you stayed in the 2005 loan. That shortened your loan payoff date to December 2024.

While the monthly payment did go up with the refinancing, it was still less than the total monthly payment estimated on the 2005 loan after the additional principal payments. To put things on an apples-to-apples basis, I structured additional principal payments on the refinancing to put you at the same total monthly payment. That shortened the 15-year refi to fewer than 13 years and had the loan paid off two months before the adjusted payoff on your existing loan. I also assume that you can fully use the mortgage interest deduction on your taxes.

If this is a reasonable match to your situation, refinancing into a new 15-year loan makes sense.

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