Q: We took out a mortgage in 2011. It’s a 30-year loan with an interest rate of 5.125%. Our expected payoff date is 2041, but we’ve been paying biweekly. We expect to pay it off in 2035.
At this point, we would like to refinance. This is what we have on the table: a 20-year loan with an interest rate of 3.25%, which will lower our payment by $331. If we pay this loan off biweekly, we will pay it off in 2037. We also have an offer for a 15-year loan at 2.75%, but our payment would go up by $50. We can handle the increase, but if we pay this loan biweekly, we will pay it off in 2033.
Both the 20-year loan and 15-year loan offer significant interest savings. Closing costs will be rolled into the loan. Which would be the best option for us?
A: Well, it seems to us that you have made it a priority to live mortgage free. Which is a terrific choice for many homeowners, even at today’s historic low interest rates.
Given your preferences to pay down your mortgage as fast as you can, we suggest you move forward with the 15-year loan. With the 15-year loan, you’ll be mortgage free by 2035, or perhaps even a few years earlier if you continue to make an extra payment per year. With your current loan, you’ll be mortgage free no later than 2041. And on your current path, you will save at least six years of interest payments.
We generally think a home run refinancing is when you can lower your monthly payments (excluding real estate taxes and homeowner’s insurance), lower your overall interest rate, reduce the time it will take to pay off the mortgage, and start enjoying the benefit of the reduced savings within six to nine months of the loan closing.
A rate reduction alone may not be sufficient for us to recommend that you refinance your loan. Frequently, the loan closing fees can be greater than the savings you’d achieve with a loan refinancing and in that case, the rate reduction is not enough.
A lower monthly payment alone is also insufficient to justify refinancing a loan. Let’s say you’re 10 years into your 30-year loan. If you refinance now in order to be able to lower your monthly payments, but add another 10 years to your loan, those additional 10 years may cause you to pay much more than the savings you are getting from the monthly payments. (And yet, if you’re going through a cash crunch, lowering your payments might be enough of a reason to refinance.)
Finally, if you find a refinance opportunity that gives you a lower interest rate, lower monthly payments, and you can pay off the loan on or before the time your original loan payoff date would occur you might be golden.
The one exception has to do with loan closing fees. Those expenses can mount quickly, which is why it’s important to watch how much you’re getting charged. Without making it too complicated, if your loan closing fees are $1,000 and your monthly payment goes down by $100, it will take 10 months until your “savings” equals the out of pocket costs for the refinance. If, however, that your loan closing costs are $6,000, it will take you five years to end up even. We’d rather see you recoup any out-of-pocket closing costs within the first year after a refinance.
Don’t confuse closing costs with other out-of-pocket costs you’ll have to pay upfront, such as taxes, insurance escrows and other costs in the decision about whether to refinance. That’s not the right way to think about it. You’ll pay those costs no matter what. We know that many borrowers will say that their monthly payment is $1,000 and include in that amount the principal repayment, interest, tax escrow and insurance. But when you’re trying to figure out what you want to do, you shouldn’t factor in the tax and insurance escrows. Just look at the principal and interest part of the payment so your comparison is apples to apples.
We also know that many of our readers believe you should take out as big a loan as possible and for as long as you can and use those funds to invest in the stock market.
Let’s say you borrowed the money at around 3% and you can use that cash to invest in stocks and earn 8% on your money. That would be neat, right? But some of our readers can’t stomach any sort of risk when it comes to their homes. These readers would prefer to know that they have paid off their mortgages, no longer have to deal with a mortgage lender and that they own their home free and clear.
We also have plenty of readers who will take out a mortgage and never prepay that loan. They will feel that they’ve borrowed money at a cheap interest rate and use the extra cash to either save for retirement or invest in or perhaps buy another property. They hope that by leveraging historically cheap interest rates, they’ll make their money work harder for them.
So, how much risk are you willing to take? Will you sleep at night if you invest the difference and the stock market declines by 30%, as it did at the start of the COVID-19 pandemic? Or, will you sleep better knowing your home is paid off.
Only you can decide what’s right for your financial and personal life.
(Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through her website, ThinkGlink.com.)
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