Does it make sense to make small additional principal payments to pay down my mortgage early?

Making small additional principal payments on a monthly basis can make a big difference in the total financing charges over the life of the loan and can also make a big difference in the total number of years it takes to pay off a loan.  However, there is a deminishing benefit to doing just that as you go from a 30 year loan to a 15 year loan.  For example by increasing you monthly payment on a 30 year fixed rate amortizing loan by a small amount, you can drastically reduce the time it takes to pay off the loan. A $250,000 30 year 7% fixed rate has a monthly payment of $1,663.26.  If you increased your payment by $100 a month you would pay off the loan in 25 years instead of 30 years.

What is the limit for a conforming loan? And why does it exist?

Conforming loan limits are standards established for the purpose of pooling loans and securitizing those loans into collateralized mortgage obligations, CMO's.  Why bother?  The end intent is to improve intermediation and liquidity and thus reduce the cost (interest rate) to you, the borrower.  Conforming loan limits are raised periodically to adjust for escalating home values. If your loan exceeds the conforming loan limit you will pay a higher interest rate. Theoretically this higher interest rate reflects the lender's increased credit and liquidity risk.

Am I the buyer or seller of a loan when I borrow to refinance or buy a home?

A misconception of many individuals is that they are the buyer of a loan when they finance or refinance their home.  But this is not true.  When you borrow to finance your home, you are the seller of the loan and the lender is the buyer.  For example, if you buy a US Treasury Security, the US Government is the seller/issuer/borrower of the security and you are the buyer/holder/lender of the security. 

Why are prevailing mortgage rates higher than U.S. Treasury rates?

The rate you pay on your mortgage is usually higher than that of an equivalent term US Treasury Security.  The difference in yield between the yield on your mortgage and an equivalent term US Treasury Security is referred to as the spread and reflects any additional risk posed to the buyer.  The two major risks are the 1) higher credit risk, and 2) prepayment risk associated with a mortgage. The prepayment risk reflects the probability that you the seller will exercise the embedded call feature or option within the mortgage allowing you the borrower to call the loan or pay it off early.  Calling the loan allows you to call the note and pay off the balance of the loan either by refinancing or just paying it off outright. 

Should I refinance?

The answer to this question is complex. There are both economic reasons and personal reasons to refinance an existing loan. For example an individual with 5 years remaining on an original 30 year amortizing loan may not desire to refinance the remaining balance into a 30 year amortizing loan, purely for personal reasons even though economically it may result in savings.

For this reason I am going to focus on the economic benefits only.

Determining the economic benefits would depend on many factors, i.e. 1) what is the rate on your existing loan, 2) what is the current rate at which you can refinance, 3) what will it cost you to refinance, and 4) how long do you expect to hold the property hence hold the loan.

Simply you would have to subtract the cost to refinance from the present value of the difference in the cash flows of your original mortgage versus your anticipated mortgage, i.e. the present value of (the cash flows of your original mortgage minus the cash flows of your anticipated mortgage) less the cost to refinance. This may sound complex, but it only complex from a mathematical standpoint yet relatively simple from a conceptual standpoint.

In determining a discount rate we assume a flat yield curve. It would be much too complex to construct a yield curve using current treasury prices by appling a process referred to as cubic splining and then subsequently discounting the difference in the cash flows between the two mortgages using the various rates along the curve that coincide with the various cash flows. It is deemed sufficient for consumer purposes to assume a flat yield curve.

If you are the average consumer and you read the above paragraph then your head is probably spinning, but if you are a professional trader of bonds then you have probably interpreted what I wrote. No matter either way, let us move on to the next step.

Bring up the following mortgage calculator Compare Two Mortgages Using Present Value and input the terms of your current mortgage and the terms of your anticipated mortgage. Use a discount rate that is the same as the rate on your anticipated mortgage (for simplistic purposes). Enter the estimated closing costs of the loan, which would include lawyer's fees, title insurance, loan application fees, appraisal fees and any other fees associated with closing and processing your loan. Process the results by clicking submit. The net figure will display the net difference in the present value of the cash flows. If you determine that you will remain in the property for a period of time less than the time to maturity then you must add up the PV of the differences in the cash flows for the years in which you will remain in the home. To be continued......please come back later.

What is a mortgage to an institutional buyer and seller, i.e. trader of CMO's?

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