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Should you refinance, or pay more toward your mortgage?

Jennifer Berry
Wondering whether you're better off refinancing or making extra mortgage payments? Here are the pros and cons of both.

You dream of a debt free life, and the biggest hurdle is your mortgage. You wonder, though, what the best path is to paying it off: Refinancing to a shorter-term loan, or just adding some extra cash onto that monthly mortgage payment? Well, the answer isn't necessarily black and white; it will depend on your specific situation.

"Before deciding whether to refinance or make extra mortgage payments, you need to determine what you want to accomplish," says Howard Dvorkin, CPA, founder of ConsolidatedCredit.org. That means looking at your long and short-term goals and deciding how long you'll likely stay in your home, he says.

To give you a head start in your research, we did some digging to uncover what some of the benefits are of refinancing to a shorter-term loan vs. making extra payments.

When You Should Refinance to a Shorter-Term Loan

"If your goal is to pay off the mortgage, refinancing to a shorter-term loan could make the most sense," says Ian Giebeig, loan originator with Bayway Mortgage Group in Florida. "Typically shorter-term loans offer better interest rates." And a better interest rate could save you a lot of money in the long run.

One important thing you'll want to keep in mind, however, is that the shorter the loan term, the higher the monthly mortgage payments. So, refinancing to a shorter-term loan is ideal for a homeowner with a stable income who is willing to commit to a higher monthly mortgage payment.

If you think you have the means and commitment to refinance to a 15-year loan, here's how much you could save:

Let's look at an example of a $200,000, 30-year fixed-rate loan. We'll use average interest rates from August 15, 2013 for a 30-year fixed-rate (4.40 percent) and a 15-year fixed-rate mortgage (3.40 percent), according to Freddie Mac.

And let's say you waited one year to refinance your mortgage. After making the minimum payment each month on your 30-year mortgage, your balance at the time of refinancing will be $187,981.76.

  Standard 30-year  15-year with refinance
Interest Rate:   4.40 percent 3.40 percent
Loan Amount:  $200,000  $187,981.76
Monthly Payment: $1,001.52 $1,338.32
Total Interest Paid: $160,547.86 $52,915.26

If you decided to refinance to a shorter, 15-year term, you'd save more than $100K over the life of the loan.

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When You Should Make Extra Payments, Instead of Refinancing

We've told you about the benefits that come with refinancing to a shorter-term loan. But refinancing might not be the best solution for everyone.

Here are some scenarios where you may want to think twice about refinancing to a shorter-term loan, and consider making extra payments instead:  

You're unsure about the stability of your income: "One pitfall to refinancing to a shorter term is if the person has a change in circumstance; for example a job-loss, income change, or medical crisis," says Dvorkin. "If the new loan amount is higher than what they had previously been paying and for some reason they are not to be able to afford the higher payment that the shorter-term mortgage requires, this may endanger their home."

Instead, if you simply make extra principal payments, it gives you flexibility to pay it off when you have the necessary means, he says.

When you can't afford the closing costs that come with refinancing: "A hefty price can be paid in a trail of closing costs if the homeowner refinances numerous times," warns Dvorkin. Closing costs can run anywhere from 3 to 6 percent of the total amount of the loan, according to the Federal Reserve.

You're close to paying off your mortgage: "If a person has a low interest rate already and is near pay-off then it would not make sense to refinance, and they should just make extra payments when they can," says Dvorkin. This is particularly important to remember as refinancing to a new loan resets the clock and prolong your payoff date.

So, How Much Can You Save by Making Extra Payments?

Wondering how much of a dent extra payments can make?

Let's go back to our previous example of a 30-year loan at 4.40 percent. The mortgage amount is $200K. Your monthly payment (interest and principal only) will be $1,001.52. Over the course of your 30-year loan, you'll pay $360,547.86 for your home.

But take a look at how much you could save if you added a few more dollars to your monthly payment:

  • If you pay just $50 more every month, you'll pay the loan off two years and 10 months sooner. And you'll pay $343,429.39 over the life of your loan - a savings of $17,118.47.
  • If you pay just $100 more every month, you'll pay the loan off five years sooner, and you'll pay only $329,814.39 for your home. That's a savings of $30,733.47!

So, the more money you can afford to pay toward your principal each month, the sooner you'll pay your mortgage off - and the more you'll save in interest.

[Click to shop around and compare interest rates from lenders now.]

The Bottom Line: What's Better?

As we discussed, that will depend on your individual situation. But one thing to consider if you decide to refinance is that interest rates are rising. And the higher they go, the less you save.

In fact, just a few months ago rates were substantially lower than they are now. According to historical data from Freddie Mac, the average rate for a 30-year fixed-rate mortgage in January 2013 was 3.41 percent, while the average for July 2013 jumped to 4.37 percent.

The risk of not locking in a lower interest rate is that you'll pay more of the life of your loan, since your interest rate is higher, says Allen.

But, if you don’t want to commit to the higher monthly payments that come with a shorter-term loan, keeping your 30-year mortgage and making extra payments might be a better idea.