- Running the Numbers
- Relative Rates of Return
- Inflation and Investing
Is it smart to refinance a 5.25% 30-year loan to a 15-year loan at 4%?
Looking to refi 30 year mortgage which have paid on for 7 years (5.25%) down to a new 15 year at 4% fixed. Is that a good plan?
The answer to your question is in the numbers. You did not mention the balance of your loan. Let us assume for the sake of argument that your starting loan balance was $200,000. If so, your principal and interest payments over the last seven years brought your loan balance down to about $175,000. Your monthly payments — excluding taxes and PMI — were about $1,105. Over the life of this loan you will pay $198,000 in interest. Now let us say you refinance the $175,000 balance to a 15-year 4% fixed. Your monthly payments — excluding taxes and PMI — will be about $1,400 a month. You will pay $66,000 in interest expense over the life of this loan.
Not included in my math are the closing costs associated with the refinance. Those will vary with the amount of the loan.
Of course, your actual figures will vary because you did not include the balance of your loan in your question, but my point is clear — if you can afford to increase your mortgage payments by 30%, and with a 1.25% decrease in the interest rate, you can cut your overall interest expense dramatically.
Relative Rates of Return
Paying less in interest expenses is A Good Thing, but not if you can put the money you use to pay off the mortgage early to more productive use. Let us say you keep your loan as-is and you put that $300 difference into investing. One missing piece in your equation is the rate of return on your investing. Look at the relative rate of return on investment vs. the interest rate on the mortgage, keeping mind that Uncle Sam is underwriting part of your mortgage interest expense.
Another missing piece the amount of retirement savings you have. A third missing piece is how long you expect to work.
If you are nearing retirement and have no plans to remain in your home after retirement, then you may want to invest the $300 into an IRA. If your retirement plans are otherwise set, then retiring the mortgage early will provide these benefits:
• You slash your interest expense.
• You have the peace of mind knowing your home is 100% yours
• In some jurisdictions such as Florida, your residence is 100% exempt from judgment, whereas savings accounts and investments can be levied by judgment-creditors.
Value of a Future Dollar Due to Inflation
One other consideration in this analysis is the value of money over time. What I am about to write is incomplete and not nuanced, but explains one aspect of future value briefly. As I write these words in mid-2010, the inflation rate has varied from zero to about 3.5% over the last 10 years. I am not a follower of financial apocalypticism. However, given the recent spending rate of the US government I believe it likely the inflation rate will increase over the next few years.
One benefit to debtors in times of inflation is they repay loans with dollars that are worth less than when they received the loan. Let me put this in concrete terms. Let us say that the US inflation rate stays a constant 3% over the next 20 years. A $10 bill today will have the same purchasing power as $18 in 20 years. If inflation averages 3.5%, a $20 bill in 20 years will have the same purchasing power as a $10 bill today. If the interest rate on your loan is fixed, then as you repay the loan you hand over the the same number of dollar bills you did on day one, but with each passing month each dollar bill you pay is worth less. Therefore, if you believe the inflation rate will stay low, then you will be inclined to repay the loan quickly. However, if you believe the inflation rate will increase, then it is smarter to repay the loan later when dollars will be worth less. High inflation, in effect, slashes the interest rate on a fixed-rate loan.
Recommendation
There is no right answer to your question. If paying off your mortgage sooner than later will provide a profound psychological benefit, then retire the mortgage as quickly as possible. Start your refinance shopping by visiting the Bills.com mortgage refinance savings center. If you are more comfortable carrying debt or have no retirement savings plan, then invest the $300 per month in a diversified portfolio and wait for the miracle of compound interest to work its magic.
I hope this information helps you Find. Learn & Save.
Best,
Bill