If you're considering refinancing, examine all the options

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If you're considering refinancing, examine all the options

Attracted by low rates, millions of homeowners continue to refinance their mortgage loans. Another option is to simply "prepay" your mortgage _ applying a little extra against principal periodically _ especially if your main goal is to cut the length of your loan and reduce the amount of interest you'll pay overall.

So what should you do: refinance or prepay? That's the question a man from Johnston, R.I., asked MoneyLine:

Q. I have a 30-year mortgage. It's fixed at 6.75 (percent), and I owe 0,000. I want to put ,000 down. My question is, is it better to pay down the mortgage to lose the years, or to convert over to a 15-year fixed mortgage at 5.6 (percent)? My objective is to drop as many years off (as possible). Basically, what I want to know is, how many years am I going to lose by putting ,000 down on the principal?

_ C.O., Johnston

A. If you refinance your mortgage under the terms you described, you could cut the length of your loan by about 14 years, said Keith T. Gumbinger, vice president of HSH Associates of Butler, N.J., a national publisher and surveyor of mortgage-loan rates. You could also save more than 8,000 in overall interest payments, he said. If you prepay _ by applying that ,000 lump sum against the principal outstanding on your loan _ you could cut between seven and eight years off your loan, and save nearly ,000 in overall interest, he said.

So refinancing in your case may be best. Without knowing more about your situation, I can't say exactly what your savings will be _ in time and money. So to look at your options in detail, let's make some assumptions. For instance, let's say you took out your existing 30-year loan last year. You now have 29 years left.

Refinance: If you refinance now, taking out a 15-year fixed-rate loan, you'll have your debt paid off in 15 years instead of 29 years.

How much interest will you save? Let's assume that, last year, you borrowed 2,000 over 30 years at a fixed interest rate of 6.75 percent.

If you stick with it, you'll end up paying a total of about 8,262 over the life of the loan, my calculator shows. That includes 2,000 in principal and 6,262 in interest.

What if you refinance now, borrowing 0,274 in a 15-year loan at a fixed rate of 5.6 percent? You'll end up paying a total of 7,257 over the life of that loan. That includes the 0,274 in principal plus about ,983 in interest.

Here's another way to look at it: if you stick with your original loan, you'll end up paying 6,262 in interest. If you switch to a 15-year loan now under the terms you described, you'll end up paying ,864 in interest overall (including interest you've already paid over the last year on your original loan, plus interest you'll pay overall on your new 15-year loan).

As a result, you'll wind up saving 8,398 in interest overall. (For convenience, I'm ignoring the impact of any fees and closing costs.) So you'll save a lot _ in time and in overall interest.

But it may not be easy. Right now, your monthly payment is about ,051, based on the assumptions we've made. If you refinance, you'll pay about ,318 a month. So to get the savings described here, you'll have to pay about 7 more a month for the next 15 years, Gumbinger said.

(If you can't make the higher payment in this example, consider setting aside your ,000 lump sum _ in a money market account or money market fund, for instance _ and tapping it over time to cover the higher amount of each monthly payment, assuming you have the discipline, Gumbinger said.)

Here's another option:

Prepayment: Prepaying your mortgage simply means making additional payments on your principal.

In our example, let's assume that, instead of refinancing, you plop down your ,000 on your existing mortgage, making sure to tell your lender you want to apply it to your principal outstanding.

You'll wind up paying off your mortgage in about 22 years, instead of the 29 years that remain on your original 30-year mortgage, Gumbinger said. You'll also save about ,800 in overall interest payments.

So by putting down an extra ,000 on your existing mortgage now, you'll also save in time and money.

Now that we've looked at both options, what do you think is better: refinancing or prepaying? In this example, refinancing looks best.

"Refinancing saves him more money over the long term, and cuts his (loan) term almost in half. . . . So (refinancing) appears to be better," Gumbinger said. And this is a good time to do it, because rates are so low, he added. As recently as 2000, for example, the fixed rate on a 30-year mortgage averaged nearly 9 percent. Now it's averaging around 6 percent _ the lowest it's been in 35 or 40 years, he said.

But lots of people can't refinance because they don't qualify, said Jordan E. Goodman, author of Everyone's Money Book On Real Estate (Dearborn; 194 pages; .95). "I get e-mails from people all the time" whose applications are rejected, mainly because they're carrying too much debt _ especially credit card debt, Goodman said.

If you're in this category, first pay down your credit card debt. It usually carries a high rate of interest, and it isn't tax deductible, said Goodman, the former Wall Street correspondent for Money magazine. You may then be in a better position to qualify for refinancing, he said.

In some cases, you may not be able to justify refinancing now because you refinanced only recently, and the lower rate you'd get now wouldn't make a significant difference, Goodman said. In other cases, refinancing might not make sense if you plan to be in your house for only a short time, he said.

If you want to prepay your mortgage instead, there are lots of methods. For instance, every other week you can make a payment that's equal to half of what you'd normally pay each month. Through these biweekly payments, you end up making what amounts to one extra month's payment per year.

By paying a bit extra on principal on a regular schedule, you can reduce the length of your loan, and save money on overall interest payments, too. It's kind of like refinancing, except that you typically don't have to deal with applications, closing costs and the like; you can do it yourself.

"Just make sure the bank knows how to credit it properly," Goodman said. Otherwise, the lender may put your extra payment into an escrow account, or set it aside to cover a future monthly principal-and-interest payment, Gumbinger said. (Goodman recommends using the lender's own prepayment program. You may have to pay a fee, but you'll be assured the extra payments you make are properly applied, he said.)

A few more points:

_Don't be obsessed with paying down or paying off the mortgage. Make sure the rest of your financial picture is in order first. For example, do you have enough life insurance and disability insurance coverage? Are you setting aside money for retirement or for a child's college education? "By and large, early retirement of (mortgage) debt is one of the best things you can do," but it shouldn't be done at the expense of your overall financial health and well-being, Gumbinger said.

_Refinancing may trigger closing costs and other such fees. Some deals may include little or nothing in fees or closing costs. Others may charge you an amount equal to 2 percent or 3 percent of what you're borrowing, Gumbinger said. So you might end up paying ,000 to ,000 in fees and closing costs on every 0,000 you borrow, he said. Goodman said, "You can cut those fees dramatically if you shop around" among lenders.

_You usually can make prepayments without triggering any penalties. Such penalties are more common with adjustable-rate mortgages than with fixed-rate mortgages, Gumbinger said. Be sure to check first with your lender, and to read your loan documents carefully (look for "prepayment penalty," "early retirement of principal," "accelerated amortization" or other such terms) to see if penalties may apply, he said.