Refinance vs. Prepayment

Weigh your options when choosing to refinance or prepay your mortgage.

Weigh your options when choosing to refinance or prepay your mortgage.

Refinancing a home can be an attractive option for couples who have built up equity in their homes and would like to cash out some of that money. A mortgage refinance basically involves payment of the home's original mortgage with a new mortgage. Prepaying a mortgage is the same as paying the mortgage down. You make extra payments to reduce your balance and the amount of interest paid on the debt. Depending on your lifestyle choices, a mortgage refinance or prepayment may be a wise decision. Both options have advantages and disadvantages.

Rewards of Refinance

A mortgage refinance involves applying for a new mortgage that will typically replace the current one. Homeowners may also receive cash back, depending on the amount they wish to refinance. If you need cash, refinancing your mortgage is a way for you to cash out equity in your home without having to sell the property. By refinancing you can also lower the interest on your mortgage by replacing it with a lower-interest loan. Refinancing a mortgage is also beneficial to couples who have improved their credit scores or those who want to switch to a different type of mortgage.

Costs of Refinance

Couples considering refinancing their mortgage should carefully look at the new loan's terms. Closing costs and other fees may increase for a refinancing. Depending on your current mortgage, you could be subject to a prepayment penalty. If you refinance late in your mortgage, your new monthly payment will pay mostly interest and it will take time for you to build equity in the property. If you plan to move in the near future, a refinance isn't recommended, especially if the costs of the transaction are higher than the savings gained.

Perks of Prepayment

Prepaying your mortgage is a way to invest excess cash and reduce interest charges on your loan. By prepaying, you will decrease your mortgage debt and build up equity in the property more quickly. Unlike other investments, prepayment also offers a guaranteed return without additional risk. For example, if your mortgage interest rate is 5 percent after accounting for the mortgage interest tax deduction, you earn this amount through a prepayment and savings in interest charges. The buildup of equity in the property may also benefit you if you decide to sell.

Downsides of Prepayment

A mortgage prepayment in the first few years of the loan can trigger a prepayment penalty. Typically, this isn't the case if you are further along in your loan term. Prepayment also requires cash you could use for something else, such as buying stocks that could provide a higher return or payment of higher interest credit card debt. Make certain mortgage prepayment doesn't adversely affect your savings or retirement goals.

 

About the Author

Eileen Rojas holds a bachelor's and master's degree in accounting from Florida International University. She has more than 10 years of combined experience in auditing, accounting, financial analysis and business writing.

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