Does it make sense to pay down your mortgage in order to be able to refinance at today's super-low rates? Is this a good strategy for homeowners who are underwater on their mortgages?

A lot of homeowners seem to think so. According to Freddie Mac, over one-quarter of all mortgages refinanced in the second quarter of 2011 were "cash-in" refinances, where borrowers paid down a significant part of their mortgage balance as part of the transaction.

At first glance, a cash-in refinance is a fairly straightforward solution for borrowers who'd like to refinance, but can't because declining property values have left them owing more on their mortgage than their property is worth. But it tends to be expensive. To get back into positive equity, underwater homeowners may have to write a check for several tens of thousands of dollars, if not more.

Generally, you don't want to do a cash-in refinance unless you're certain it's the best use of your money. Here's some of the main things to consider when deciding whether a cash-in refinance makes sense for you.

How much can you save?

This is the obvious one - that's why you want to refinance in the first place. An online mortgage calculator makes it easy to plug in the new interest rate and mortgage term, compare it to your current one, and see what you'd save on interest, both monthly and over the life of the loan. It will also show what your new monthly mortgage payments would be, so you can see how your cash flow would be affected.

How much could the money earn for you elsewhere?

This is the big question. If you're paying down your mortgage principle by $20,000-$50,000 in order to refinance, that's a lot of money. How much of a return could you get on that money if you invested it elsewhere? Is it more than you could save over the life of the mortgage by refinancing? Remember, reducing your mortgage interest by 1-2 percent is the same as earning a return of 1-2 percent on an investment.

One thing that works in favor of a cash-in refinance is that the money you put in is leveraging a reduction on your total mortgage debt. So if you've got a $200,000 mortgage balance and put up $40,000 to be able to reduce your interest rate by a single percentage point, that's like earning 1 percent interest on the entire $200,000! To get that same kind of return, you'd have to have an investment that paid 5 percent on the $40,000 alone.

Are you taking full advantage of a 401k and other retirement accounts?

If not, most financial consultants would probably say you shouldn't be thinking about a cash-in refinance. Here's why: Money that goes into a 401k or Roth IRA is tax-deductable - whatever you put in comes right off the top of your taxable income, up to certain limits.

That essentially means you're saving whatever you would have paid in taxes. So if you're under 50, in the 28 percent tax bracket and put in the maximum $5,000 per year you're currently allowed for a Roth IRA ($6,000 for age 50 and over), you're saving $1,400 up front (28 percent of $5,000). Plus the money continues to appreciate until you retire. It's hard to match that kind of return by refinancing a mortgage.

You still have to pay taxes on the money when you eventually tap it after retirement, but for most people that's going to be at a lower tax rate than they're currently paying. Also, most investment advisers would tell you that it's more important to have a secure next egg for the future than to cut your mortgage costs today.

Other tax issues

In figuring out what you could save by refinancing, don't forget to take tax impacts into account. You may be able to save $3,000 a year in interest by refinancing, but remember, that's tax-deductable interest. So if you're in the 25 percent tax bracket, for example, that $3,000 would normally get you a $750 reduction in your taxes - so your actual savings from refinancing would be $2,250.

You should also be aware that reducing your mortgage interest payments could push you below the threshold for itemizing deductions on your taxes. This is particularly true for couples with midsize mortgages who filed jointly, or single filers with smaller home loan balances.

For example, if a couple refinances $250,000 into a 30-year fixed-rate mortgage at 4.5 percent interest, their total interest payments in the first year will be $11,167.49 - less than the $11,600 standard deduction for a couple filing jointly. Unless they have additional deductions, they won't be able to itemize.

Risk of falling home values

Probably the biggest hazard of a cash-in refinance is the possibility that home values may continue to fall. In that case, you'd just be throwing good money after bad - if you put in $30,000 toward a cash-in refinance, and the value of your home falls another $20,000, that's $20,000 you've lost. Although home values will begin to rise again eventually, it's hard to say when that might be - it could be years before you make up that loss. So before doing a cash-in refinance, you want to be confident that your local real estate market is on firm footing.

Can you afford it?

There's an old line about buying things on sale - can you afford to save that much money? Paying down your mortgage balance to qualify for a lower interest rate may look good on paper, but how's it going to affect your overall finances? Saving $3,000 a year in interest or shortening up your loan term to 15 years might not do you much good if you've tapped out your financial reserves.

Most financial advisors suggest that you keep at least 3-6 months of living expenses set aside as an emergency fund. With the economy still faltering, some suggest even more is prudent. It can be in an interest-bearing account, just as long as you ready access to the cash if you need it.

Some people may also overreach by trying to qualify for one of those ultra-low 15-year fixed rates, which presently are running around 3.5 percent. In this case, they may not only tap out their financial reserves, but also boost their monthly mortgage payment in an effort to shorten their loan term. The combination of higher near-term expenses and no cash reserves is a recipe for disaster - it won't do you any good to position yourself to save $50,000 in interest over the life of the loan if you end up defaulting before you're one-third of the way there.

Further information:

  • Mortgage refinance FAQ
  • Mortgage refinance
  • Fannie Mae
  • FHA Streamline Refinance
  • FHA Loans
  • VA Loans
  • Jumbo Loans
  • Documents you need for a mortgage refinance
  • Second mortgage