With interest rates hovering at historical lows, it may seem like common sense to refinance your mortgage. Refinancing a mortgage could be a great strategy to free up monthly cash flow, lower your total amount of interest being paid, and/or shorten the length of time that you’ll be paying the mortgage. Any one of these benefits could be a reason to refinance. Collectively, you may think it’s a no-brainer, but not so fast…
The choice to shorten the length of your mortgage payments to 15 years is extremely attractive. In fact, it’s so attractive that I‘m often asked my opinion on the subject. While I love the idea of being mortgage free, I am not sure that refinancing is always the best answer.
Let Me Explain
Let’s take a look at your situation (based on a random set of numbers picked out of thin air) and assume the following details of an original hypothetical mortgage at the time you purchased your home:
- Current Home Value – $500,000
- Original Mortgage – $400,000
- 30 year rate – 4.5%
- Based on the above information, the principal and interest will be $2,027.
In order to refinance, we would want to accomplish some or all of the following:
- A lower mortgage payment
- A mortgage that can be paid off sooner than originally projected
- A lower interest rate
In order to evaluate our options, let’s assume that 2 years have passed, interest rates have fallen, and your mortgage balance is lower. More specifically, we can assume the following:
- A new 15-year mortgage is being offered at 3.5%
- The balance of your mortgage is $386,691
Based on the current market rates illustrated above (Note: these are not intended to be representative of any current market), the new mortgage payments assuming a refinance (with zero additional fees) into a 15-year mortgage will be $2,764.
Making the Argument to Refinance
When evaluating these numbers, it’s very easy to make the argument to refinance:
- Your mortgage could be paid in full 12 years earlier than expected!
- You could lower the total amount of interest paid by nearly $200,000!
- You could lower your interest rate by 1%.
Sounds easy! Just looking at these statements it may seem like an obvious choice to refinance (we are assuming that if you do choose to refinance, you can afford a monthly payment that is $700 more than your original payment. As long as you can meet that monthly nut, refinancing may seem like a great idea).
Not So Fast! Making the Argument Not To Refinance
Before you pull the trigger on refinancing into a 15-year mortgage, I encourage you to consider your alternatives. More specifically, there are 2 alternatives to consider:
- Alternative 1 – Make additional payments on your existing 30-year mortgage that equal your projected 15-year payment.
- Alternative 2 – Save and invest the difference between the 15-year and 30-year payment.
Alternative 1 – Have your 30-Year Payment Equal your 15-Year Payment
Let’s assume that instead of refinancing into a 15-year mortgage, you simply make an extra monthly payment on your existing mortgage EQUAL to what your 15-year mortgage payment would have been.
What if you paid $2,764 each month, instead of paying the required $2,027?
Making that extra payment will decrease the total amount you owe on your mortgage. In fact, we can calculate what your mortgage balance would be in 15 years (when the refinanced mortgage would have been paid off). In 15 years, your remaining mortgage balance would be $49,785.
However, if you were to refinance to a 15-year plan, your mortgage would be zero. If you make the extra payments, you will still have a balance.
Shouldn’t I refinance then?
While it may initially appear that you should refinance, we still need to continue with our example. There are three additional factors that need to be addressed before making the final decision.
The Impact on your Tax Return – A lower interest rate is a good thing. It means that you will pay less interest to the mortgage company over the course of your loan. It also means that you will pay your mortgage off quicker than if the rate was higher.
Unfortunately, a lower interest rate may also mean more money owed in federal income taxes each year. The interest you pay for your home is considered an itemized deduction. The smaller the interest paid, the smaller the itemized deduction; the higher the taxable income, and the more you may owe in income taxes.
If we compare a newly refinanced 15-year mortgage to the existing 30-year mortgage, we can approximate the negative tax impact that a refinance may have in the first year. The tax deduction will be approximately $3,800 smaller with a 15-year than a 30-year plan. In a 25% tax bracket, that equates to an additional $950 in taxes that may be owed in the first year (to be fair, the negative tax impact does become less impactful every year).
The Impact of Inflation – Still owing nearly $50,000 at the end of 15 years seems like a big number – and it is! However, it’s important to remember that the $50,000 you hypothetically owe is owed 15 years from now. As we all know, a dollar today may be worth less than a dollar tomorrow.
$50,000 in 15 years could be worth approximately $30,000 (assuming a 3.5% inflation adjustment).
If you consider the impact of inflation, in addition to the negative impact of the tax adjustment discussed above, the benefit of refinancing is decreasing.
Personal Flexibility – After considering the math and the geeky calculations, it often comes down to personal decision making. Are you someone that wants to have your mortgage paid off? Do you want to focus on obtaining the lowest rate possible? If so, then refinancing may be the best idea for you. Remember, though, once you are in a 15-year mortgage, it may cost you if you change your mind and want to get out.
If you, like me, are someone who likes flexibility, then keeping the 30-year mortgage may be your best bet. At least with the 30-year mortgage, you may have additional options of whether or not to save the money, invest the money, or pay more on your mortgage.
Alternative 2 – Save and Invest the Difference
The above example takes into consideration a lot of moving parts, including additional payment on the mortgage, inflation and tax adjustments, and limited flexibility with your resources.
Let’s assume that you take the difference between the 30-year mortgage ($2,027) and the 15-year mortgage ($2,764) and invest it. Let’s also assume that $737 per month grows at a hypothetical 7.5% for 15 years. At the end of 15 years, you would have amassed $244,029.
If you continued to make the required $2,027 monthly payment on the 30-year mortgage payment for 15 years, the balance after 15 years would be $245,023.
With your saved money, you could nearly pay the mortgage off in full (as always, in an effort to be fair, there may be a negative tax impact to selling investments and creating cash), all while having the flexibility of managing your own money.
The Best Option?
As usual, there is no best option here. For some, paying off their mortgage quicker is the key ingredient to financial success and it’s where they want to focus their energy.
For some others (like myself), maintaining a mortgage while increasing flexibility through savings in a non-IRA is the right answer.
The solution may also be age dependent. I have countless pre-retirees and retirees who are interested in paying down their mortgage as quickly as possible, regardless of the math. On the other hand, my younger clients tend to be okay with a longer mortgage for the time being.
What do you think? Are you interested in paying off your mortgage sooner? Or do you believe that you can invest that difference and potentially reap a bigger reward down the road?
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation. Tax services are not offered through, or supervised by, Capital Analysts or Lincoln Investment.
Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth.
The above hypothetical numbers are for illustrative purposes only and do not attempt to predict actual results of any particular mortgage rate or investment.