Dear Dr. Don,
Our mortgage rate is 4.375 percent. We have a $170,000 in principal and eight more years on the loan. Our monthly payment — including real estate taxes — is $3,200.

It’s risky to keep this high monthly payment with the economy getting worse at each recession cycle. I’m trying to decide to either pay off the loan early or refinance.

The trouble with a refinance is that even with the low rates, I can’t seem to find one that with an annual percentage rate of at least 1 percent lower than what we currently have on the loan.

Should we pay off the loan or wait to see if the rate would go lower and refinance? Your response is greatly appreciated.
— Jacqueline Jumble

Dear Jacqueline,
You need to sort through your financial goals and prioritize what you’re trying to accomplish with the mortgage. If you have the money to pay off the loan, you have enough of a financial safety net to not have to worry about the higher monthly payment.

Incidentally, the real estate taxes being part of your monthly payment isn’t really germane. You’ll owe the taxes regardless of how the home is financed.

The old rule of thumb that you shouldn’t refinance unless the new mortgage rate is at least 1 percent less than the old interest rate isn’t the best yardstick for determining whether you should refinance. The decision to refinance to capture a lower interest rate should be based on the after-tax interest savings, net of closing costs, over the time you plan to be in the house.

You’ve got a great rate on your mortgage. You could get a similar rate in refinancing and extend your mortgage term out to 15 or 30 years. That will bring down the monthly payment, but you’ll wind up paying a lot more in interest expense, as shown in the table below:

Increased interest expense
Existing mortgage New 15-year mortgage New 30-year mortgage
Loan amount: $170,000 $170,000 $170,000
Interest rate: 4.375 percent 4.06 percent 4.56 percent
Loan term (months): 96 180 360
Mortgage payment: $2,102 $1,263 $867
Total payments: $201,788 $227,266 $312,277
Total interest: $31,788 $57,266 $142,277
Total interest after tax (.28) $22,888 $41,231 $102,439
Estimated closing costs: $ – $3,741 $3,741
After-tax interest plus closing costs: $22,888 $44,972 $106,180

The after-tax cost estimates are based on a marginal federal income tax rate of 28 percent and assume you can fully use the mortgage interest deduction on your federal income taxes.

If your goal is to refinance to achieve a lower monthly payment, that’s easy enough to do. You won’t save on interest expense, because you’ve extended the term of your loan.

Making additional principal payments on the new loan can reduce the term and interest expense to about where you are now. But the only advantage to that is that the additional principal payments aren’t contractual, and you could skip them if it wasn’t in your budget that month.

You’re paying a price for that financial flexibility. Most of that price comes from the closing costs on the refinancing.

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