July 28, 2016
Many mortgage borrowers view extra payments and refinancing as alternatives and are confused as to which would serve them better. This article is directed to them.
Extra Payment Decisions Versus Refinance Decisions
While borrowersrefinance for several possible reasons, only those taken 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 must 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. Mortgage Refinance Calculator 3a pulls these and other factors together to quantify the savings and costs.
The prepayment decision, in contrast, is best viewed as an investment decision. The funds used for extra payments are or could be invested in CDs, 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% on a debt and you pay it off, the funds used for that purpose earn 5%. 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 Versus 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.
Here are some illustrative numbers. The mortgage rate is 4%, the assets used to fund loan repayment yield 3%, and the borrower could refinance into a 3.25% mortgage that would be profitable over 10 years. In this case, the borrower should pay off the mortgage because the 3% cost is less than the 3.25% rate on the mortgage after refinancing. On the other hand, if the borrower is earning 4% on the assets used to fund the loan repayment, he should leave the assets alone and refinance.
Periodic Extra Payments and Refinance
The second situation is where a borrower making or planning to make periodic extra payments, may also have an opportunity for a profitable refinance. In this case, the borrower can do both, but they may affect each other. A rate-lowering refinance reduces the rate of return on future extra payments, which could induce the borrower to reduce or stop such payments. However, the principal motivation for making extra payments seems to be to get out of debt faster, and the refinance won’t change that.
Extra payments made in the past don't affect the refinance decision to be made now, though such payments would have made today's loan balance smaller, which reduces the benefit from a refinance.
Extra payments that borrowers expect to make in the future should be factored directly into the refinance decision process. Extra payments reduce the expected life of the loan, which (other things the same) reduces the benefit from the refinance. In using the refinance calculator, you should shorten the term of the new mortgage accordingly. If you plan to refinance into a 30-year loan, for example, but extra payments would result in payoff in 20 years, you should use 20 years as the term. On the other hand, if the lower refinance rate induces you to terminate the extra payments, you should use the longer mortgage term in assessing the refinance.
You can assess whether or not a refinance would be profitable HERE.
FAQs
Consider making extra payments or paying off your mortgage early. If you're looking to save money on your mortgage, refinancing isn't the only option. Making extra payments on your mortgage can save you money on interest over time. You could also consider paying off your mortgage early.
How many years does a 2 extra mortgage payment take off? ›
But if you have a relatively recent loan, you're likely looking at tens of thousands of dollars in savings and cutting as much as eight years off the life of your loan. Obviously, not everyone can afford to make two extra mortgage payments a year. You're basically increasing your housing costs by 16%.
What happens if I pay an extra $1000 a month on my mortgage? ›
Throwing in an extra $500 or $1,000 every month won't necessarily help you pay off your mortgage more quickly. Unless you specify that the additional money you're paying is meant to be applied to your principal balance, the lender may use it to pay down interest for the next scheduled payment.
What happens if I pay 3 extra mortgage payments a year? ›
Paying a little extra towards your mortgage can go a long way. Making your normal monthly payments will pay down, or amortize, your loan. However, if it fits within your budget, paying extra toward your principal can be a great way to lessen the time it takes to repay your loans and the amount of interest you'll pay.
Is it smart to pay extra on your mortgage? ›
Since your interest is calculated on your remaining loan balance, making additional principal payments every month will significantly reduce your interest payments over the life of the loan.
What happens if I pay an extra $2 000 a month on my mortgage? ›
The additional amount will reduce the principal on your mortgage, as well as the total amount of interest you will pay, and the number of payments.
How can I pay off my 30 year mortgage in 10 years? ›
Here are some ways you can pay off your mortgage faster:
- Refinance your mortgage. ...
- Make extra mortgage payments. ...
- Make one extra mortgage payment each year. ...
- Round up your mortgage payments. ...
- Try the dollar-a-month plan. ...
- Use unexpected income. ...
- Benefits of paying mortgage off early.
Ideally, you want your extra payments to go towards the principal amount. However, many lenders will apply the extra payments to any interest accrued since your last payment and then apply anything left over to the principal amount. Other times, lenders may apply extra funds to next month's payment.
How to pay off a 200k mortgage in 5 years? ›
Let's say you currently owe $200,000 on your mortgage and you want to pay it off in 5 years or 60 months. In this case, you'll need to increase your payments to about $3,400 per month.
What happens if I pay an extra $400 a month on my 30 year mortgage? ›
If you pay an extra $200 a month toward the principal, you can cut your loan term by more than 5½ years and save $98,277 in interest. If you increase the extra payment by $400 per month, you not only shorten your mortgage by nine years, you save $159,602 in interest.
When you pay extra on a mortgage, you're paying above and beyond the regular monthly installment. The money you send is meant to apply directly to the loan principal, not the interest. This allows you to pay down your loan sooner and save money on interest.
What happens if I pay an extra $600 a month on my mortgage? ›
By making a small additional monthly payment toward principal, you can greatly accelerate the term of the loan and, thereby, realize tremendous savings in interest payments.
What happens if I overpay my mortgage every month? ›
Once you've made an overpayment, you can't get a refund – and remember that you'll need to make your monthly payments as usual. Every overpayment you make means you pay less interest overall on the money you borrowed from us. Overpayments do one of two things to your mortgage balance, depending on the amount.
How many years do two extra mortgage payments take off? ›
The difference two extra mortgage payments can make
| Original payment | Difference/savings |
|---|
| Monthly pay | $1,678.74 | +$280.00 monthly |
| Total payments | $604,346.93 | -$111,720.71 |
| Total interest | $324,346.93 | -$111,720.71 |
| Payoff in years | 30 years | -9 years |
May 29, 2024
Extra payments toward your loan's principal (or the amount of the loan) can reduce the total amount you repay by reducing the total interest you pay. When you make extra payments, you can also reduce the loan's terms and pay your debt down faster. It can also lower the amount of your future monthly payments.
Will interest rates go down in 2024? ›
Yes, mortgage interest rates are expected to go down a little in 2024, then more noticeably in 2025.
What happens if you miss 2 mortgage payments? ›
What Happens with the Second Missed Mortgage Payment. If you miss your second mortgage payment, the lender will probably contact you to find out why. You can explain your situation and the lender may be able to put you on a plan where you pay less money or no money for a little while.
What happens if you make 2 mortgage payments? ›
No, making biweekly or twice-monthly payments will not change your loan's interest rate. But by making more frequent payments, you can reduce how quickly interest accrues, which helps you lower the total interest paid over the life of the loan.
Is it ever a good idea to take out a second mortgage? ›
By investing in your property, you're using home equity to build more equity, in effect. Using the second mortgage to pay off other loans or outstanding credit card balances is arguably another good reason — especially if those obligations carry a higher interest rate.
How much faster will I pay off my mortgage if I pay every 2 weeks? ›
Biweekly payments accelerate your mortgage payoff by paying 1/2 of your normal monthly payment every two weeks. By the end of each year, you will have paid the equivalent of 13 monthly payments instead of 12. This simple technique can shave years off your mortgage and save you thousands of dollars in interest.
