Knocking a couple of years' worth of interest off your mortgage by making prepayments can save you a lot of money in the long run. But if you’re planning to refinance your mortgage, consider skipping those prepayments and using that extra money to cover the refinance’s upfront closing costs.
Making additional principal payments will help you pay off a mortgage sooner. For example, prepaying an extra $100 a month towards your principal on a $200,000 30-year fixed-rate mortgage (FRM) at 6.5% would save $55,944 in interest and would shorten your loan term by five years and seven months. (Figure out what prepayments would do in your situation by using BankingMyWay.com's Mortgage Payoff calculator.)
But those savings are only realized if you keep your mortgage until it's paid off -- selling your home or refinancing your mortgage in the early stages of your loan reduces the impact of those prepayments dramatically.
For instance, if you start prepaying $100 of principal with your very first monthly payment but end up refinancing your mortgage after just two years, you'll owe $2,555 less when it comes time to refinance -- $2,400 of principal prepayments and $155 in interest you saved by paying off that much of your principal early. While that's not a bad return on your $100-a-month investment, consider that $2,400 is around what it would cost you to refinance your mortgage at a lower interest rate.
The one-time, upfront cost of refinancing can lower your monthly payments and save bundles on interest in the long- term. The money spent at closing doesn't go towards paying down your principal as it would with a prepayment, but you stand to save more money in the long-term with a lower interest rate.
So, while owing less on your existing mortgage can help you get a better rate when it comes time to refinance, you might be better off saving that $100 per month and putting it towards your closing costs.
For instance, refinancing your existing mortgage (in the above example) with a new mortgage at an interest rate of 5.33% after two years -- the national average on 30-year FRM, according to BankingMyWay.com's Rate Index -- could lower your monthly payments by $175 a month. That's a much better return on your $2,400. (To see how much refinancing could save you, check out BankingMyWay.com's Refinance Breakeven calculator.)
Your savings could be even greater if you qualify for a lower rate than the national average. For instance, residents of the New York metropolitan area can apply for a 30-year FRM from Sovereign Bank (Stock Quote: SOV) at 5.125%, from KeyBank (Stock Quote: KEY) at 5.25% or from HSBC (Stoke Quote: HBC) at 5.125%.
Just remember to consider how long you plan on staying in your home after your refinance. If you leave before you can recoup the upfront costs of refinancing, the refinancing may actually cost you money instead of saving it.
For more on refinancing: