Both refinancing and extra loan payments save you interest and let you pay off your mortgage years ahead of schedule. If you plan to stay in your house for a while and lenders are offering low interest rates, refinancing to a shorter-term mortgage with higher payments is a smart choice. But simply sending in extra principal payments on your existing loan takes little effort and makes more financial sense for some borrowers.
By refinancing into a shorter-term loan, you commit to higher monthly payments. For example, payments on a 30-year, $150,000 mortgage at a 3.6 percent interest rate are $682 per month, while a 15-year, $150,000 mortgage at 2.8 percent interest requires $1022 per month. By making extra payments on your own without refinancing, you still pay off the loan in less time and with less total interest, but you have a lower minimum payment to fall back on if you lose your job or if an emergency expense arises.
Making extra payments doesn't change the interest rate you pay. If interest rates are lower than your current rate, or if your credit score and income have improved since you took out your mortgage, you may save a significant amount of money by refinancing. Even if everything else has stayed the same, shorter-term mortgages generally carry a lower interest rate than longer ones. Choosing a 15-year rather than 30-year mortgage could shave about 0.8 percentage points from the interest rate. For example, you would pay about $33,870 in interest over the life of a $150,000 loan with a 15-year term at 2.8 percent interest. If you took out a $150,000 loan with a 30-year term at 3.6 percent interest, you could pay it off in 15 years by making extra payments, but you would still pay $44,350 in total interest because of the higher rate. Of course, the greater the difference in interest rates, the more you'd save by refinancing.
Time and Costs
As long as your loan doesn't have a prepayment penalty, you don't have to pay any fees for making extra payments. Refinancing, on the other hand, incurs closing costs that can amount to several thousand dollars. Depending on how long you decide to stay in your home, this may mean refinancing costs more than it saves. Making extra payments is more convenient than refinancing, also: you still send in your monthly mortgage payment, but for a higher amount. Refinancing requires you to shop for a loan, apply, provide documentation and be available for an appraisal and the closing.
Lump Sum Payment
If you come into a lump sum of money, such as a bonus or inheritance, your lender may agree to recast your mortgage. In a recasting, you pay down a portion of your mortgage and the lender recalculates payments over the remaining loan term based on the lower principal balance. You can combine recasting with extra payments on the amortized loan. This would allow you to save on total interest, while giving you a lower payment to fall back on if an emergency hits.
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