Last week, I talked about refinancing your mortgage to improve cash flow, but without extending your time horizon. Today, I want to talk about something slightly different… Refinancing your mortgage to accelerate your mortgage payoff.
For now, we’ll set aside the debate over whether you should pay off your mortgage early or string it out and focus on investing. We’ve covered that topic extensively in the past so, for today, I’ll just assume that the decision has been made.
As before, I’d like to highlight the possibilities with a concrete example… Bob and Sue bought their home ten years ago using a standard $240k, 30-year fixed rate mortgage at 6.5%. Since then, they’ve consistently made their required payment of $1, 517/month (principal + interest), and their balance has dropped to $201k.
If they just keep on keepin’ on, they’ll be mortgage free in 20 years – at which time they’ll have paid a total of $278k in interest. Yikes! Once they see that they’ll pay more in interest than the original balance of their mortgage, they decide to get out of debt as quickly as possible. Unfortunately, their budget won’t support extra mortgage payments, so they’ll have to think creatively.
After shopping around, they find a 15-year fixed rate mortgage for 3.5% APR. Nice, right? Actually, that’s slightly above current mortgage rates, but it’s a nice round number, so let’s just go with it. And yes, I’m once again ignoring the costs associated with refinancing. Given that we’re using an above-market rate, let’s just say that they found a no-cost refinance deal.
Running the numbers
Despite cutting the amortization time in half, their monthly payment will drop to $1, 437 thanks to that super low rate. And, of course, their mortgage will now be wiped out in 15 instead of 20 years. The cost? A little under $58k in interest on the new mortgage plus $134k in interest payments already made during the first ten years for a total of $192k in interest payments.
Wow! That’s $86k in savings, and they’ll be mortgage-free five years early. Not too shabby. But remember, they decided that they wanted to get out of that mortgage as quickly as possible, so why settle for a lower payment? Why not keep making the original payment, and apply the $80 monthly excess to their principal?
If Bob and Sue do this, they’ll save a little more than $4k over the straight 15-year scenario, bringing their total cost down to $187k in interest payments, for a total of $91k in savings. Plus, they’ll be mortgage-free about a year earlier, meaning that they’ve now shaved a total of six years of their mortgage.
All of this is possible simply because they refinanced to a lower rate (and a shorter term) while continuing to make their original payments. Of course, any additional money that they can scrape up and send with their payment will accelerate things even further, so it pays to look for corners to cut, or ways to earn extra money.
I completely agree with “someguy” I would give up $6,000 any day for the flexibility of needing that extra cash one day.
We’re about to refinance a rental home to a new 30-year mortgage, and the reason we’re not going with a 15-year loan is the one “someguy” mentioned: we want the flexibility to drop to the lower payment if the need arises. We don’t anticipate the need arising, and our plan is to keep making the same payment we do now… and the rate drop is enough that we’ll pay the mortgage off faster with the new loan than with the current one. So while it might not be as big of a “win” as a 15-year loan, it’s still a win… and the better choice for us at this point.
There’s a simple rule when it comes to debts. Unless the debt is interest free, continuing to borrow the money is costing you money. If you can earn interest on savings or get a return on other investments, it usually benefits you to pay off the debts and invest your money. Except, if you are overpaying to reduce your debts this can leave you short if there should be an emergency and some lenders dislike people repaying more quickly than they should and charge fees and impose penalties for early repayment. So, applying the general rule, you should always pay off the most expensive loans first. That means those store cards, credit cards and high interest loans you are carrying. Under normal circumstances, mortgage interest tends to be less than commercial loans
Another interesting option/take would be to refi on a 30-fixed loan instead of 15-fixed and apply the “savings” in monthly payment as additional principal each month.
If you assume the numbers above and a 0.5% interest rate spread between 15 and 30 years, the 30-year loan is $477/mo less. If that $477 is applied to the 30-year each month, it is paid off only 9 months later than the 15-year and having paid approximately $12.5K more in interest. If the spread is 0.25%, the payoff is 6 mos later and $6K more in interest.
Obviously neither $6K nor $12.5K are trivial amounts, but that must be weighed against the flexibility/cash flow provided. If a job is lost or another, better return on cash comes along, the option to drop to a lower payment might be huge. Or if kids come into the picture and 2 incomes become less than 2.
Any further increase in extra principal payment benefits the 30-year+difference plan somewhat more than the 15-year plan since the rate is higher and the interest more front-loaded.
We just refinanced to a 30 year at 4%, but we’re very disciplined and put in an extra $1000 toward the mortgage every month. We’ll be paid off in 11 years, but we do have a “cushion” of having a very low required payment just in case something goes wrong (lost job, big medical bill, etc).
This is why we want a 15-year mortgage off the bat!