Refinance for lower rate, but longer term?

Bankrate.com

Dear Dr. Don,
I have five years and eight months remaining on my 15-year mortgage loan at 4.875 percent, and the monthly payment is $1,403. My current banker has offered a so-called mortgage rate reduction with a new 10-year rate of 2.75 percent and a payment of $801 per month. Do you think that I should take this offer? What are my advantages? Will I save more or less with this refinance offer?

Your prompt response to my inquiry is greatly appreciated.

Thank you!
-- Steve Speedy

Dear Steve,
With the refinance, you'd be extending the current term of your mortgage from 68 months to 120 months, or 10 years. Even though there's a substantial drop in the interest rate, you won't save on interest expense because of the loan extension. The numbers below tell the tale.

'Mortgage rate reduction' math

Existing mortgageRefinanceDifference
Loan amount$83,214$83,953+ $739
Interest rate4.875%2.75%- 2.13 points
Loan term (months)68120+ 52
Loan payment$1,403$801- $602
Total interest expense$12,190$12,168$22

The difference between the two loan amounts comes from estimating them based on the loan terms, interest rates and payment amounts you provided.

The question becomes: What are you going to do with the extra $602 per month that the mortgage rate reduction provides in your monthly budget? If you use it to make additional principal payments on the new mortgage, assuming there's no prepayment penalty, then you can capture additional interest savings. You'd save about $5,700 and have the new 10-year loan paid off in five years and five months, or three months faster than your existing mortgage.

I haven't considered the impact that the reduced interest expense could have on the mortgage interest deduction on your taxes. Even with the potential loss of that deduction, it's still a winning strategy to take advantage of the lower mortgage rate and use the savings to pay down your loan balance.

If you have other ideas for the $602 you'd save each month through the refinance, then those plans will help determine whether it makes sense to take advantage of the mortgage rate reduction. Since you haven't shared any such plans with me, I can't say that it would be a good idea to extend the loan term but not make the additional principal payments.

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