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With rates so low, should I refinance or pay-off my mortgage?

With interest rates on the 30-year mortgage below 3%, now might be a good time to refinance or even pay off your mortgage balance early. When does it make sense to choose one or the other? 

To simplify the discussion, we'll make two assumptions: First, you do not have any other debts outstanding such as a credit card balance or personal loan. Second, the amount of the loan remains the same. Refinancing to tap equity (cash out) or consolidate other debts might be appropriate, but it can also be a way to never-ending and increasing debt. Consequently, it brings up additional issues beyond the scope of this conversation.  

Why should you refinance? 

The main benefits are:

  • Reduced monthly payments by securing a lower rate. However, the total amount of interest you'll pay over the loan's life might be higher as you extend your payments further in the future.
  • Shorter length of loan by switching from a 30-year loan to a 15-year loan. This strategy will typically reduce the total amount of interest paid, but it will raise your monthly payments. For instance, a 30-year $300,000 mortgage at 3.5% requires monthly payments of $1,347. The same 15-year mortgage at 2.5% requires $2,000 a month.
  • Faster equity build-up: Depending on the rate and term of your new loan compared to your current one, the principal portion of your payments could be higher.
  • Avoid future upward adjustments: Switching from a variable-rate to a fixed-rate loan allows you to secure and set your monthly payments.
  • Other less frequent reasons, such as going from jumbo to conforming loan or getting rid of mortgage insurance...

What are the drawbacks? Refinancing entails costs such as commissions, origination, appraisal, and other fees. You should only consider refinancing when those can be offset reasonably quickly by the projected savings. Calculating your breakeven point is easier when securing a lower monthly payment than when switching from a 30-year to a 15-year loan. It is usually a bad idea to refinance when you expect to sell your house within 2 or 3 years. 

Why would you choose to pay off your mortgage balance instead? 

Key reasons are:

  • To get a higher return on your money. Accelerating principal repayments or retiring a 3.5% loan entirely may be better than letting cash sit at the current 1% or less earned on your savings account or CD.
  • Peace of mind: A mortgage payment is usually the most significant monthly bill for a household: some people, particularly retirees, like the serenity from being debt-free.

What are the factors to consider before paying it off? The principal issue has to do with a concept called "opportunity cost." A 3% mortgage is a very low-cost form of borrowing. Could you reasonably expect to earn a higher rate of return from your total assets (home + investments) over the life of that mortgage? If you do, the difference between the two rates applied to your loan balance will help you build your net worth faster. With the effect of compounding and depending on the loan rates and size, it can add up to a six-figure difference in wealth over 30 years. This is the hidden cost of not carrying a mortgage balance.

Some pundits argue that today's low rates on CDs and savings accounts make the payoff more attractive. In doing so, they implicitly assume that this is the appropriate rate of return to compare against. Although it might be the case, we believe that the relevant bogie is the return on all your assets, not just your cash balance. Multiple factors could tip the scale against paying off your mortgage. For instance:

  • Location, location, location. For most people, their home is their biggest asset. What return can you reasonably expect in your neighborhood after netting out property taxes, maintenance, and insurance?
  • Investors who own stocks, bonds, and mutual funds with an aggressive asset allocation are more likely to earn returns above current mortgage rates. 
  • Taxpayers who itemize deductions can deduct property taxes and mortgage interest. It reduces the after-tax cost of your loan even further, thereby enhancing the odds of earning excess returns from your assets.

A second disadvantage of paying off the balance, particularly for retirees, is the reduced liquidity. These funds won't necessarily be easily accessible in an emergency. Older households living off their investments and social security don't have the same ability to borrow money. Once the loan is repaid, they lose that flexibility.

The bottom line is that the decision to refinance or pay off a mortgage balance needs to follow a review of rates, terms of the loans, portfolio asset allocation, tax and income situations. The best financial move might not be the one you just read about.

Refinance or pay off?


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