Refinancing a Late-Term Mortgage

My 9% mortgage will be paid off in eight years. Does it make sense to refinance now?

These days, only people with truly terrible credit ratings should be stuck paying 9% for their mortgage. Most everyone else — even those who are nearing the final stretch of their mortgage payments — could save themselves some cash by refinancing.

The question is, how best to refinance?

There are three main money-saving options. Which one is best for an individual depends on his or her goal — whether it's to shorten the repayment terms, cut the monthly payments or both. No matter what, each option should be discussed further with a mortgage lender.

Traditional Refinancing
This is the most expensive route in terms of closing costs. Refinancing a $30,500 mortgage could set you back around $1,500, says Doug Perry, senior vice president at Countrywide Home Loans.

Since there are no eight-year mortgage products out there, refinancing makes sense only if the homeowner takes out a 10- or 15-year loan and then prepays it, says Keith Gumbinger, a vice president at HSH Associates, a Pompton Plains, N.J., real-estate information firm. "Otherwise, the cost of credit goes up substantially," he says. "Can you imagine being near your goal of not having to make a mortgage payment and then signing on to another 15 years' worth?" (The average interest rate of a 15-year fixed-rate mortgage is currently 5%, according to Bankrate.com. The interest rate for a 10-year loan should be slightly lower. Data are as of July 21.)

For those who are comfortable with their original monthly payments but are looking to pay off their loan more quickly, Gumbinger suggests making prepayments equal to the difference between their old and new payment.

So what are the potential savings? According to HSH, someone refinancing a $30,500 balance at 9% to a 5.5% 10-year mortgage could save nearly $5,000 — factoring in $1,500 in out-of-pocket closing costs — if they kept their mortgage payments at $424. And that's not counting the tax savings, given that mortgage interest is tax-deductible for most people. Because of the prepayments, the loan would be paid off in just seven years and four months. (For more details, please see table below.)

Home Equity Loan
Another option is a home equity loan (HEL). The closing costs of HELs are significantly lower than those of refinancing — usually in the hundreds of dollars, according to Gumbinger — but the interest rates are higher. The good news is that, for most people, interest payments are tax-deductible.

Right now, borrowers with good credit can take out a $30,000 HEL for about 6.5%, according to Bankrate.com. HELs have a set repayment term of five, 10, 15 or 20 years, so this scenario would also require prepayments.

In our example, the overall savings are lower and repayment terms are longer than they would be with a refinance, but the results are so close that a difference in the actual closing costs or interest rates in either scenario may tip the scale the other way. Therefore, it's worthwhile to discuss both options with a lender.

Home Equity Line of Credit
The cheapest route in terms of closing costs and interest rates is paying the current balance with a home equity line of credit (HELOC). A HELOC is basically a variable-rate credit line (based on the home's equity) that the owner can use pretty much like a credit card. There are no closing costs associated with HELOCs, and right now the interest rates are dirt cheap: The average interest rate for a $30,000 HELOC is a mere 3.67%, according to Bankrate.com.

Where this gets tricky is that the rate is variable — it fluctuates based on the prime lending rate, which is currently 4.25%. (The Bankrate.com figures cited earlier are slightly lower because they factor in the low introductory periods offered by many HELOCs.) In today's environment, it's almost certain that the rate on a HELOC that's opened now will increase in the near future. Granted, there's a lot of wiggle room for someone who's currently paying 9%. "No matter what happens to interest rates during the next rising interest-rate cycle, it's a fair bet that you won't see a 9% rate again," Gumbinger says. Once again, the interest on this loan is tax-deductible.

For many folks, the potential downside of HELOCs isn't rapidly rising interest rates as much as the allure of the checkbook that comes along with HELOCs. Since this is an open credit line, untapped credit could be used for treats like a kitchen makeover or a family vacation. The other disadvantage of HELOCs is that the repayment terms aren't as specific as those of a HEL or a second mortgage. "(HELOCs) are not structured to give you rigid repayment terms," says Gumbinger. "They're intended to be flexible credit instruments. You're going to need a little bit of discipline in order to pay the loan back within eight years." Many HELOCs allow homeowners to make interest-only payments while the line of credit is open, which may be helpful in an emergency, but could also lengthen the repayment period.

To stay on schedule, you should first determine the minimum monthly principal payments. Next, with a timeframe in mind, divide the total loan principal by the number of months you have to repay the loan, and each month add the interest charges to it. For example, for $30,500 to be paid back over eight years (96 months), you would have to pay at least $317 a month toward principal. Add to that the monthly interest charges (those should be written in your statement) each month and this amount should be your payment. Keep in mind that, as interest rates rise, so will your interest payments.