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How You Know Whether to Refinance or Prepay on Your Mortgage

NEW YORK (TheStreet) -- The rise in interest rates since spring has taken the oomph out of the refinancing craze, because a homeowner replacing a 6% loan won't save as much if the new one charges 4.5% instead of the 3.5% available last May. Still, refinancing can pay if you'll keep the mortgage long enough, so it's worth running the numbers.

It's also worthwhile to look at an alternative: keeping the old loan but making extra principal payments to pay it off early. If refinancing would produce only a small rate cut -- 1% or less, for instance -- prepayments might save more money in the long run and be less of a headache to put into action.

With a standard, fixed-rate mortgage, prepayments won't reduce your monthly payment, which is one of the chief benefits of a refinance. But by allowing you to retire the debt earlier, prepays can substantially reduce the borrower's interest costs -- which is really what refinancing is all about.

And with prepays, you don't have any fees, while a refinance can cost thousands in loan origination fees, appraisal charges and other closing costs. Also, there's no approval involved in a prepay, an important consideration if you think your refinancing application might be rejected.

Imagine you had taken out a $300,000 loan in 2006 at the going rate of 6%, for a monthly payment of about $1,800. Today, you'd still owe about $263,000. (Assuming eight years of payments had been completed.)

If you refinanced the balance for 22 years at 4.5%, your payment would drop to $1,571, a nice $229-per-month savings. (Taking out a new 30-year loan to replace one with just 22 years left would cut your payment more but would not pay overall because you'd add eight years of payments.)

With the new 4.5% loan, interest charges would total $151,776 over the next 22 years, compared with $211,522 over 22 years if you kept the old loan. Total savings: $59,746.

Now suppose that instead of refinancing you used that $2,000 available for closing costs to instead reduce the mortgage balance, and suppose you made $200 a month in prepays. This would cut total interest for the next 22 years to $163,294 instead of $211,522.

So the prepay option would not be quite as valuable over time, leaving you with about $163,000 in interest still to pay versus about $152,000 if you refinanced. But spread over 22 years, the difference would be fairly small.

Now suppose your current mortgage charged 5%, a common rate in 2010, instead of 6%, and you'd had it just three full years? Would it pay to refinance to 4.5%? You might not find a 27-year deal, so let's assume you'd refinance for a full 30 years.

With the refinance, you'd pay $235,683 in interest over the next 30 years. If you prepaid as described before -- $2,000 now and $200 a month -- interest would total $221,709 and the loan would be paid off in 292 months instead of 360. So the prepay option would be about $14,000 cheaper.

In this case, where a refi would cut the rate only 0.5 percentage points, the prepay would save more over the long term. The downside, of course, is you'd have to kick in that extra $200 a month on the prepay. But that $200 would go to principal, and it's money you're going to pay anyway, whatever option you choose.

Of course, different closing costs, interest rates and prepayment amounts would tip the balance among these options. (Here's a good calculator for that.)

But the bottom line is clear: As refinance rates rise, there comes a point at which prepayment on the existing mortgage is the better choice.

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