Save with a Refinancing, Prepay Combination

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Homeowners are flocking to refinance their mortgages, using today’s low rates to slash monthly payments, often by hundreds of dollars.

But there’s an opportunity to save even more by using spare cash to reduce the size of the new loan. Instead of refinancing all $200,000 still owed on old mortgage, for example, you could take out a new loan for $150,000, using cash to make up the difference.

It’s the same strategy many borrowers use when they make mortgage prepayments. But when coupled with a refinancing, the benefits of paying down the debt are immediate instead of delayed, because the monthly payment is smaller.

Many homeowners make extra principal payments, either regularly or in occasional lump sums. Paying down principal, or outstanding debt, reduces interest charges, often saving tens of thousands of dollars over time and allowing the homeowner to pay the debt off years ahead of schedule.

But homeowners with fixed-rate mortgages don’t enjoy any immediate benefit because, even after big prepayments, their required monthly payments stay the same as when the loan was issued. The long-term payoff comes because less of each payment goes to interest, leaving more to pay the debt down faster. (Look at this story for how prepayments affect adjustable-rate mortgages.)

Imagine a homeowner who borrowed $300,000 about 10 years ago, when fixed-rate loans averaged around 7.5 percent. Today, 30-year fixed-rate mortgages charge about 5.13 percent, according to the BankingMyWay.com survey. With a shopping around, you can find a 20-year mortgage for around 5 percent, giving you the same payoff date you had with the old loan.

By refinancing the $260,386 debt remaining on the old loan with a new 5 percent loan for 20 years, the homeowner would cut the monthly payment from $2,100 to just over $1,700.

Instead, the homeowner could pay off part of the old loan with $50,000 in cash. With the new loan for just $210,386, the payment would be cut another $300, to just under $1,400. If the same $50,000 were put in later, sometime after the new loan was issued, the payment would stay at $1,700.

Use the Fixed Mortgage Loan Calculator to try your own numbers.

Does this refi/prepay combination really make sense?

It depends on the alternatives for the prepayment money. In effect, the prepayment funds, $50,000 in this case, are invested in the home. The return is 5 percent, since each dollar of prepayment saves you 5 percent in interest charges every year.

If you could get 7, 8 or 10 percent investing elsewhere, it would make sense to do so. Stocks might well return more than 5 percent, but at much greater risk.

Since the 5 percent prepayment return is a sure thing, it should be compared to comparable fixed-income investments like certificates of deposit. Five-year CDs average just 2.26 percent, according to the BankingMyWay.com survey.

While that seems to make the prepayment a winner, remember that this money would be tied up for the long term at a 5 percent return. With a CD or other liquid investment, you can get your money out more easily, for another purpose or to invest at a better return if rates go up.

Still, a 5 percent return is not bad for a guaranteed investment, and by reducing your mortgage payments you free up other cash to invest every month.

Use the BankingMyWay.com mortgage shopping tool to hunt down an attractive mortgage, and be sure to look at local banks in addition to nationwide firms like Bank of America (Stock Quote: BAC) and Wachovia, which is part of Wells Fargo (Stock Quote: WFC).

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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