The Mortgage Professor

Jack Guttentag
Saturday, July 4, 2009

Some of the most difficult questions I receive from readers concern the relationship between making extra mortgage payments and refinancing.

I have never been very happy with my answers, and recently took a harder look at how making extra payments and refinancing are related. My hope was that if I understood it better, I could answer the questions better. This article reflects my current understanding, followed by new answers to some common questions.

Extra-payment decisions and refinancing decisions should be made independently because they are based on very different factors. Yet each may affect the other, which is why it is easy to become confused.

The extra-payment decision is best viewed as an investment decision. The money used for extra payments could be invested in CDs or bonds where it would earn the return being paid on those assets. Instead, it is invested in reduced mortgage debt, on which it earns a return equal to the mortgage rate.

What mortgage rate? The rate the borrowers would have paid on the balance they pay off, which is their current mortgage rate. In principle, if they anticipate that they will refinance to a lower rate, then that lower rate is the one that will be earned on the extra payments. That won't apply until after the refinancing, when the extra-payment decision could be reconsidered.

It is very doubtful, however, that a rate-lowering refinance induces many borrowers who have been making extra payments to reduce those payments. The principal motivation for making extra payments seems to be to get out of debt faster, and refinancing won't change that.

Borrowers refinance for several reasons: to reduce the interest rate, reduce payments, reduce risk of future rate increases, to raise cash. Only rate-reduction refinances may be affected by extra payments.

The decision to refinance to reduce rates involves a judgment that the savings from the rate reduction, over the period the borrower holds the new loan, will more than cover the refinance costs.

The three most 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. (Calculator 3c on my Web site,, pulls these and other factors together to generate an answer.)

How can extra payments affect the refinance decision? Those made in the past don't figure directly in current decisions. However, past payments have reduced the loan balance, which reduced the benefit from a subsequent refinance. As balances become smaller, the benefit from refinancing shrinks and at some point disappears. Indeed, few lenders are interested in refinancing loan balances of less than $50,000.

Extra payments that borrowers expect to make in the future should be factored directly into the refinance decision. 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. 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.

Here are three questions I receive quite often:

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