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Which is better, making extra mortgage payment or refinancing?
Many mortgage borrowers at some point consider making extra payments or refinancing but are confused as to which would serve them better.
• Extra Payment vs. Refinance
While borrowers refinance for a variety of reasons, only refinancings undertaken to reduce the interest rate can be viewed as an alternative to making extra payments. Borrowers should refinance to reduce the rate if the savings from the rate reduction over the period the borrower expects to hold the new loan will more than cover the refinance costs. The three most important factors in this judgment are the size of the rate reduction, the refinance costs as a percent of the balance and the life of the new loan.
• The prepayment decision, in contrast, is best viewed as an investment decision. The funds used for extra payments are or could be invested in certificates of deposit, bonds or other assets and would earn the return being paid on those assets. Instead, they are invested in reduced mortgage debt on which the borrower earns a return equal to the mortgage rate. Yes, you read that correctly. If you are paying 5 percent on a debt and you pay it off, the funds used for that purpose earn 5 percent. The borrower should make extra payments if the mortgage rate exceeds the rate of return on the assets the borrower would hold otherwise.
• Because they are based on very different factors, extra payment decisions and refinance decisions should be assessed independently. Yet each may affect the other, which is why it is easy to become confused. Two situations arise where borrowers are seemingly faced with a choice between making extra payments and refinancing.
• Complete Payoff vs. Refinance
One situation is where the borrower has a sizeable amount of assets that could be used to pay off the mortgage in full, and also has an opportunity to lower mortgage financing cost by refinancing. He should pay off the loan if the return on the assets used to fund the payoff is below the rate on the mortgage after refinancing. Otherwise, he should refinance.
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