Prepay your mortgage or refinance your home?
Here's a look at which tactic provides the better bang for your buck.
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Q: 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. (Bing: What are interest rates on 15-year mortgages right now?)
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. Our monthly principal payment also would increase 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
A: 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 payment.
- On our blog, 'Listed': Obama pushes Congress to OK refinance plan
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, more of your monthly payment goes toward the repayment of principal.
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Because the loan payment doesn't change after you make an additional principal payment, the loan term changes; you will repay the loan faster than the stated term. You can use a 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%.
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.