May 21, 2001
"I want to refinance my
8% 30-year mortgage, taken out in 1996, without starting the 30-year
amortization period all over again. I read recently that the best way to
do this is to borrow an amount equal to the original balance, then
immediately prepay an amount equal to the difference between the original
balance and the current balance. Do you endorse this?"
No, there are better ways to
accomplish your objective.
Assume you took out a $250,000
fixed-rate mortgage in 1996 for 30 years at 8%. Your monthly mortgage
payment was $1834.42. If you made no extra payments, your balance 5 years
later would be $237,674. You now have an opportunity to refinance at 7% on
a new 30-year loan, but you want to pay off in 25 years, as you would have
if you hadn�t refinanced. There are 3 ways to do this.
Shorten the Term: The
simplest way is to make the term on the new loan 25 years instead of 30.
Then your new payment will be $1679.84 instead of $1581.25, but it would
still be below your current payment. Many lenders offering 30-year loans
will permit 25 and 20-year terms at the same rate.
The only weakness of this approach
is that it is not exact because lenders won�t customize the term to suit
the borrower. For example, a borrower with a 30-year loan that is 3 �
years old can�t get a new loan for 26 � years. Because of the limited
choice of terms that are available, most borrowers are obliged either to
accelerate or slow amortization.
Borrow the Original Balance
and Prepay: In the approach you read about, you would borrow the
original amount of $250,000 for 30 years, then immediately prepay $12,326.
The prepayment would result in paying off the loan in 25 years and 8
months. This approach is not exact either.
But that is a minor problem. The
major problem is that by borrowing more than the balance, the loan is
classified as a "cash-out refi", which typically is priced
higher than a refinance covering the balance only. In addition, all costs
expressed as a percent of the loan will be higher, including points,
mortgage broker fee, mortgage insurance and title insurance. Furthermore,
depending on the property value, the larger loan could trigger a shift
into a higher mortgage insurance premium category.
Add to the Payment: A
much better alternative is to refinance the current balance for 30 years,
but increase the payment by the exact amount required to amortize over the
period you wish. In your case, instead of paying $1581.25 you would make
the 25-year payment of $1679.84.
The beauty of this approach is
that it is exact. For example, assume a borrower with a 30-year 8% loan
that is 3 � years old wants to stay on the original amortization schedule
with a new 30-year 7% loan. This is done by adding $61.42 to the scheduled
payment of $1581.25. A payment of $1642.67every month will pay off the
loan in exactly 26 � years.
How do you determine how large the
extra payment must be? Go to the calculator Extra
Payments Required to Pay Off By a Certain Period. You tell the
calculator when you want the loan to pay off, and it will tell you the
extra payment required to do it.
Of course, the extra payment is
not obligatory, which can be viewed as a drawback or an advantage. It is a
drawback if you lack the discipline to pay more than you are legally
obliged to pay. It is an advantage if you have the discipline, and value
the flexibility of being able to skip the additional payment in a pinch.
Copyright Jack Guttentag
2002
