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Q: I’m eight years into my 30-year mortgage, but I want to pay it off faster. Am I better off refinancing to a 15- or 20-year loan, or just paying a bit extra toward principal each month on my existing loan?
A: A key calculation is to figure out whether your savings in total interest payments will be greater than the costs of refinancing. While shorter-term loans generally have lower interest rates, that doesn’t automatically mean that you’ll be saving money.
Add the cost of refinancing — your closing costs will typically amount to about 2% to 5% of the loan value — to the cost of your new payments. (For a 15-year loan, for instance, multiply your revised monthly payment amount by 180, for 15 years x 12 months.) If that total figure is less than what you’d lay out by simply increasing your monthly payments by the same amount until the balance of your principal is paid off, then it would make financial sense to refinance to the shorter-term mortgage.
Before you commit to a refi, however, take stock of your cash flow. Whether you’re upping monthly payments or refinancing, you’ll probably wind up shelling out more cash each month. If you’re not sure your budget will have room to cover unexpected expenses over the long term, give yourself more flexibility by simply making extra principal payments for now, says Charles Ricketts, a certified financial planner based in Midlothian, Va. That way, if things get tight, you can revert back to the standard payment.
If you’re just making extra payments, make sure your payments are applied to the principal balance, rather than the interest, says Washington, D.C. financial planner Carl Holubowich — so you’re eating away at the loan more quickly.
One final caution: Before you start shelling out more money each month, make sure you wouldn’t face any pre-payment penalties, Holubowich says. Check your loan terms to see if a payment applies during your loan — and if it does, how much you can prepay without incurring a fee and what the fee is if you exceed that limit.