Refinance a Mortgage Without Extending the Term?
May 21, 2001, Revised November 12, 2007
The simplest way to refinance without extending the term is to select a new mortgage with a shorter term. This is very inexact, however, because loans are available only for a few standardized terms. Borrowing an amount equal to the original balance and immediately prepaying the difference is exact but costly, because the new loan is classified as a cash-out refinance. Much the best method is to refinance at the same term, but increase the payment by the amount required to amortize over the period you wish.
"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.
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. The rate on 25-year loans is usually the same as that on the 30, but 20-year terms carry lower rates. See Wholesale Price Tables and Charts.
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 ½ years old can’t get a new loan for 26 ½ years. Because of the limited choice of terms that are available, most borrowers are obliged either to accelerate or slow amortization.
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 refinance", 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.
I recommend against this approach.
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 ½ 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 ½ years.
How do you determine how large the extra payment must be? Go to calculator 2c, 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.
The simplest way to refinance without extending the term is to select a new mortgage with a shorter term. This is very inexact, however, because loans are available only for a few standardized terms. Borrowing an amount equal to the original balance and immediately prepaying the difference is exact but costly, because the new loan is classified as a cash-out refinance. Much the best method is to refinance at the same term, but increase the payment by the amount required to amortize over the period you wish.
"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. The rate on 25-year loans is usually the same as that on the 30, but 20-year terms carry lower rates. See Wholesale Price Tables and Charts.
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 ½ years old can’t get a new loan for 26 ½ 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 refinance", 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.
I recommend against this approach.
Increase the Payment as Needed
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 ½ 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 ½ years.
How do you determine how large the extra payment must be? Go to calculator 2c, 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.