Things to Think About Before You Refinance Your Mortgage

Larry Swedroe posted an interesting article on how to do the math on a mortgage refinancing to find out whether or not it’s to your benefit to refinance. He used the following example:

• 12 years left on a 15-year mortgage.

• Current mortgage rate is 4.75%.

• Current monthly payment $1,369

• Current balance on the mortgage around $150,000 (this is the amount to be refinanced).

This couple is looking to refinance into:

• 15-year mortgage.

• $150,000 loan.

• $3,000 in closing costs (to be paid upfront).

This couple is in the 25% income tax bracket.

So…based on those numbers, would it be a good idea to refinance?

Well, as Larry points out, there are a lot of things to consider before jumping into a refinance.

1. In this example, the spread between the two interest rates is less than a 100 basis points (less than one percent). Naturally, the bigger the spread, the more advantageous it is to refinance.

2. There is more to the calculation than simply looking at the difference in payments since the payment includes principal, which is your own money. So, we have to look at the difference in the interest portion of the payment.

3. As Larry also points out, interest payments are tax deductible (if you itemize your deductions). Larry uses the 25% income tax bracket for his example. Based on that, the couple is paying $.75 for each $1.00 of interest. Basically, what this means is that this makes the refinance less advantageous (you’ll see this in the spreadsheet).

4. This couple is already three years into their loan. They are looking to refnance into a new 15-year mortgage. That means they have paid 3 years of interest on the old loan and will be paying 15 years of interest on the new loan for a total of 18 years of interest.

5. The closing costs are paid upfront.

After running the example, I came to the conclusion that refinancing this loan will cost an additional $702 in after-tax interest. I arrived at this number by adding up the three year’s of interest paid on the original loan plus the 15 year’s of interest on the new loan. Were they to continue with the old loan, they would have paid a total of $70,417 in interest ($52,812 after-tax in a 25% income tax bracket).

What Larry leaves out, in my opinion, is a discussion of the opportunity cost between the two loans. By choosing to refinance, this couple would be freeing up cashflow that could be put to work elsewhere (unless they are using the cashflow to shore up their budget). The payment difference of $296 per month could be invested elsewhere for the next 12 years. Using a monthly total return on the S&P 500 Index of .75% (including a management fee), that $296 per month payment difference could grow to more than $112,000 in 15 years. If they invested the $3,000 plus the entire $1,369 monthly payment for 3 years after the end of the original mortgage, they would have over $60,000 at the end of 15 years. Another thing worth mentioning is that all of the $296 per month could be put into a Roth IRA where only a portion of the $1,369 payments could be put in a Roth because they would exceed the Roth limits.

Based on those numbers, the refinance looks like a no-brainer. But, I left out three things: 1. Investing in the stock market is not a sure thing and 2. I didn’t make adjustments for taxes, which favored the refinance. 3. In order for the scenario to work, the payment difference MUST be invested and not spent.

With that said, I am making available the spreadsheet I used for this post, which you can download here: Mortgage Amortization Comparison (Two 15-year Mortgages). I didn’t spend a lot of time making it user-friendly but if you understand the basics of Excel, you can get in there and change up the variables yourself.

The 15-Year Mortgage Is Gaining in Popularity

I just read A 15-Year Mortgage Isn’t for Everyone over on Yahoo Finance. The author basically says what I have said in the past.

According to the article, more people are choosing the 15-year mortgage than during the past. Why?

The financial situation of the people capable of refinancing today is a factor in the shift, Walters said. These people typically are homeowners with the best credit and the most equity—and, therefore, most suited for a shorter-term loan.

But there might be some psychology at work. “We’re seeing a different view on debt than maybe we’ve seen in the past,” he said. Today, homeowners are saying, “I really want to pay this off. I’m going to bite the bullet and take the payment and work toward paying this down.”

I will admit that I like this new shift in thinking. I think it’s good for people to have a fear of debt. But, I think that fear of debt should be directed at credit cards and other unsecured debt. I call that “bad debt.”

Anyway, the article mentioned something that I thought was interesting:

“There was a drive a couple of years ago to take out the biggest mortgage that you could and use all of the money you would have otherwise had in the house and put it into stocks and bonds — to think of your house and mortgage as part of your entire investment portfolio,” said Amy Crews Cutts, deputy chief economist for Freddie Mac.

That’s not what I remember people doing a few years ago. I remember people taking out their equity to pay off other debts or to take vacations or to buy a car. I don’t remember people using their equity to buy stocks. I’m sure some people did this, but I don’t think the bulk of them did.

Anyway, the article mentions that 15-year mortgages aren’t for everyone. I agree. I think a person needs to do the math and look at their budget. If flexibility is important, then a 30-year is the way to go. Extra payments can always be made to help pay off the loan faster (if that’s your thing). Also, consider what other ways the extra payments towards the principal can be used. Should a person be paying down their mortgage faster if they aren’t maxing out their retirement plan? All things to think about.


A Look at Mortgage Interest

How Much Mortgage Can You Realistically Afford? I apologize for the poor layout of this post.

Your Mortgage May Not Be As Expensive As You Think It Is

Mortgage Loan Comparison Calculator

This Probably Comes as No Surprise…

From Bloomberg:

More than half of U.S. borrowers who received loan modifications on delinquent mortgages defaulted again after nine months, according to a federal report.

The re-default rate of loans modified in the first quarter of 2009 was 51.5 percent by the end of the year, the Office of the Comptroller of the Currency and the Office of Thrift Supervision said in a joint report today. The figure, which measures payments at least 30 days late, climbed to 57.9 percent for changes made in the prior 12 months.

U.S. homeowners are struggling to make payments as depressed housing prices leave them owing more than their properties are worth. About 24 percent of properties with a mortgage were underwater in the fourth quarter, First American CoreLogic said last month. The median price of a U.S. home was $165,100 in February, down 28 percent from its peak in July 2006, according to the National Association of Realtors.

Is this a surprise to anyone?

Now the administration is looking at requiring lenders to cut mortgage payments for the unemployed to no more than 31% of income. I googled and found that the average unemployment check is $293 per week (rounds to $1,270 per month). That works out to a mortgage payment of less than $400 per month. It’s a temporary measure but wow. If you lent someone $200,000 to buy a house, the payment would be about $1,200 per month (assuming a 6% interest rate for 30 years). Had the bank lent the money WITH NO INTEREST, the payment would have still been over $555 per month.

I wish the administration would concentrate on CREATING JOBS rather than trying to dictate private matters. You create jobs and all the rest of this stuff will take care of itself.

One AFM Reader’s Response to a New York Times Op-Ed Piece

AFM reader, “EZ,” sent me an email with a link to this op-ed piece that was recently published in the New York Times. The op-ed piece was about how the bankruptcy process should be easier so that “American families torn apart by the economic upheavals of the last two years…” (Ronald Mann’s words) can move on with their lives.

EZ’s response was quite good:

Good Morning Sir,

I just read your Op-Ed piece in the online NY Times. I disagree with your premise as summarized by your last paragraph.

“Such a bold reshaping of the bankruptcy system would provide Americans immediate respite from crushing debt and the ceaseless emotional and financial pressure that comes with it. Then they could turn their attention to finding new jobs, moving into housing they can afford and caring for their families.”

I believe making it easier to declare bankruptcy would only put more pressure on citizens who are responsible, pay their debts and taxes, and positively contribute to our economy and country. My wife has been in the mortgage business for nearly 30 years and she thinks your idea is wrong headed. She has experienced people, well before the meltdown, who had declared bankruptcy and waited 2 years to purchase another house. Inevitably, when she told them they were purchasing too much home for their income, they would respond by saying that if they couldn’t make the payments, they would declare bankruptcy again. A lot of folks have lost jobs or are experiencing reduced wages through no fault of their own but many more people who used their homes as a bank to pay for vacations and new cars or who bought homes they really couldn’t afford are in trouble by their own volition and irresponsibility. If we make it simple to declare bankruptcy, these people will use it as a financial turnstile to once again live beyond their means at our expense.

Take a look at the US savings rate over the last 10 years. So many were living paycheck to paycheck, not planning for a financial misstep. Also look at the lifestyles of these same people. New cars, houses they could not afford and vacationing like there was no tomorrow. Too much credit, not enough responsibility. And yes, there are others that share the blame. Congress, banks, regulators, credit ratings companies and overpaid CEO’s. But at the end of the day, it was the consumer who purchased homes, cars and vacations they never could afford.

Why do you think people should not honor their debts and commitments? Who made them buy the house they could not afford? By the way, just because a homeowner is underwater on their mortgage doesn’t mean they cannot afford to keep paying for their home. It just means they cannot use the home as a bank anymore.

I truly do not mind helping people who are in need. But I do mind when someone tries to make me help someone who lived irresponsibly and is now looking for a handout(that includes corporations). Making it easier to declare bankruptcy punishes those of us who lived frugally and responsibly. In this area, I believe my wife has much more experience than you do. So many times she told borrowers they were trying to get a mortgage they could barely afford. Most times she was told that they did not care and if my wife would not do the loan, they would find someone who would. My wife lost a lot of business that way.

First sentence of the second section of the Declaration of Independence: “ We hold these Truths to be self-evident, that all Men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty and the pursuit of Happiness.” It only guarantees the Pursuit of Happiness, not happiness itself.

Have a Great Day!


Doing the ‘Right’ Thing – A Topic That Will Not Die

Just watched this video clip on Larry Winget’s facebook page:

Regardless of what the guy does, he’s in deep doo doo. He paid $340,000 (financing $272,000) for a house that is now worth between $120,000 and $140,000. He can afford the payment but is still thinking about walking away since the purchase is no longer in his favor. I wish I had more details regarding his situation but I don’t. That one advisor who talks about the after-tax cost of the mortgage makes some sense in that the true cost of the mortgage is less than this guy thinks it is.

Still, using a current value for the house of $140,000, at a 3% appreciation rate, it would take 30 years for the house to appreciate back to the purchase price. An appreciation rate of 5% would take 18 years. Bottom line: this guy’s going to be underwater for a long time.

Addressing a Dave Ramsey Fan’s Comment

My old Dave Ramsey posts regarding comparisons between the 15-year and 30-year mortgage still receive comments from time to time. This afternoon I noticed the following comment (on this post) that I want to address:

In the comparison above the amount in savings is only listed for the 30 year mortgage. Where does this number come from? Multiplying $458 times 180 (months) come to $82440. Nonetheless, one really important peice is missing. If I am in the 15 year category, and I just paid off my last payment of $1696. How’s about I save $1696/mo for 15 years and then let’s compare savings accounts. At the end of 15 years of saving $1696 (as I paid off my mortgge after 15 years), my savings account reads a sweet $305,280. Did I miss something?

His comment refers to this graphic:

Mortgage Comparison Snapshot

Let’s look at this reader’s questions, one at a time:

In the comparison above the amount in savings is only listed for the 30 year mortgage. Where does this number come from? Multiplying $458 times 180 (months) come to $82440.

The savings is the difference in payment amounts between the 30-year and 15-year mortgages. I went on the assumption that the person could afford either mortgage and that the payment difference would be saved and invested.

Simply multiplying $458 by 180 ignores the potential investment growth. In the example, I used an 8% growth rate. Granted that rate has turned out to be high given the bad markets we have had recently. But the 8% number is well within reach over the long-term.

The reader then goes on to say…

Nonetheless, one really important peice is missing. If I am in the 15 year category, and I just paid off my last payment of $1696. How’s about I save $1696/mo for 15 years and then let’s compare savings accounts. At the end of 15 years of saving $1696 (as I paid off my mortgge after 15 years), my savings account reads a sweet $305,280. Did I miss something?

Yes, he missed something. If you look at the graphic, you’ll see that I do in fact assume that after the 15-year mortgage is paid off the payment ($1,696) is invested at an 8% rate of return for the next 15 years. That’s why the savings account balance at the end of 30 years is $587.009 rather than the $305,280 that the commenter mentions ($1,696 x 180 months).

Anyway, I won’t go into all the details of that post. You can read it here along with all the very thoughtful comments that followed.

Ignoring Your FICO Score Can Cost You Dearly

Check out this graphic I found on the myFICO website:


I took the information found in that chart and made another graphic showing just how much interest a person would pay over a 30-year mortgage depending on their credit score:

FICO and Mortgage Interest

As you can see, the difference is significant. Just moving from the second highest to the highest FICO Score ranges saves you nearly $10,000 in interest over 30 years (even more if you factor in growth on the $27 per month payment difference). The difference from the lowest to the highest ranges, is nearly $100,000 in interest expense over 30 years (or nearly $200 per month)!

My advice to anyone looking to finance a purchase is to first GET A HANDLE ON YOUR FICO SCORE! The $16 spent to find out your score is an investment—especially if you have no idea what your FICO score is. The information provided to you by myFICO is easy to understand. They also show you areas that are hurting your score and things you can do to improve it.

Then take the time and effort to improve your score. Remember the two most important areas of your FICO score are:

• How timely you are with your payments, and

• How much you owe compared with your total available credit.

I would keep those in mind, along with the other items that go into calculating your credit score (found here) if a major purchase in your future.


My FICO Score is 794. What’s Your Credit Score?

The 2009 Personal Finance How-to Roundup

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How Long Will It Take to Improve a FICO Score?