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.
For : Smitty19518, ABOUT TAXES ON A FORGIVEN DEBT - You may want to consider reading I.R.S. Publication 4681 (It is about how if you qualify you may not have to pay taxes on a forgiven debt)
Smitty19518 - Do some research, I understand that the IRS has a form to file with your 1040 in which if you can prove financial hardship they will forgive federal taxes owed on a forgiven debt.
If you itemize....
Another thing to consider. If you itemize, you have likely seen that each year your interest deduction is smaller and smaller. Soon, the interest burden might not be enough to boost you over the standard deduction. Make your January payment close to but before the end of December to effectively increase the deduction one last time by one month. Then pay it down or better pay it off. Unless you are a great investor and can earn more dividends and gains than the interest you are paying (never mind putting the balance in an interest bearing account - rates are not going to be anywhere near what you are being charged for quite some time - if ever) it makes sense to stop paying interest by paying it off. Consider pre-pay penalties as well. Once you have paid it off, start to rebuild your savings by the amount you would have paid for principal and interest and don't forget to set aside property tax and insurance so you are not caught with a surprise bill. You are in a position that many would like to be - maybe have savings built up by the time interest rates start to increase. Think of it as paying yourself interest instead of the bank. Mortgage debt is often thought of as good debt, however, it is still an out-flow that you can afford to reduce.
My advice in general is to pay it off ASAP. The experts will tell you you're better off taking the tax break - but note you're getting a bigger tax break because you're pay more interest and you're only getting, if you're typical somewhere in the neighborhood of 20% of that extra interest in tax breaks.
Additionally, many say you're better off investing the difference between the cost of paying it off faster and not doing so but the fact is most people won't save the money. In '93, most of my friends scolded me for going against the experts and taking a 15-yr instead of 30-yr mortgage when the rates dropped a few percent that year and everyone was refinancing. I my mortgage was paid off several years ago and those friends still have to pay until 2023. And they didn't "invest the difference" as planned.
@ Bob Scanlan - actually you can get a loan on a house for 60K (the minimum is 50K) - depending on 1. the bank you're dealing with 2. your credit score 3. the worth of the home.
I recently purchased a home and based on the amount I was putting down one of the homes I was looking at would've given me a 53K loan, and it was approved though I didn't take the house in the end.
If they are, in fact, paying 10ish % on their home loan...they should've done a re-fi two or three years ago. They'd have to be living under a seriously large rock to have never heard of the process, so I"m wondering what their credit score is like that they haven't done it yet...
Refinance as soon as possible that is great but what if your house does not appraise for enough? That has happened to me twice now and I paid $400 for the appraisals and I have a terrible loan paying 12% interest. I have been trying to refinance for years but still unable to because of the appraisals. I do not have $10,000 just lying around to put towards the loan either living from paycheck to paycheck. Any helpful advice would be appreciated.
You caught a break and saved $35,000.... set up a payment plan through the IRS.
AND you have over 3% savings in interest per month.