Why you may never want to pay off your mortgage
Here's a look at the costs and benefits of continually refinancing your home loan.
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Given record-low mortgage rates, does it make sense to ever pay off your mortgage?
No, I don't mean not making your mortgage payments, although even that can make sense under some limited circumstances. I'm referring to a strategy of refinancing your mortgage to a new 30-year loan every 10 years or so. You would then use the cash savings to pay down higher interest debt or invest for higher returns. This approach has been advocated (PDF) by financial guru Ric Edelman, but other financial gurus such as Suze Orman and Dave Ramsey recommend the opposite: paying your mortgage off as soon as possible.
So who's right? Well, as usual, it depends on your situation. Let's take a look at some of the potential costs and benefits:
How much equity do you have?
Given the recent decline in home prices, you may not have as much as you thought. This could be a problem, since you usually need to have equity to refinance at all — unless you qualify for one of these programs. Also, you generally need to have at least 20% equity to refinance without having to pay private mortgage insurance. If you're paying PMI, you may need to refinance your mortgage to get rid of it in the first two to five years, even if you have 20% or more equity, depending on the terms of your current loan. It's even worse if you have lender-paid mortgage insurance, in which case you may need to refinance to get rid of it no matter how much equity you have or how long you've had it.
How long will it take you to recoup any upfront costs?
There are several different costs to keep in mind here. First, check to see if your lender charges a prepayment penalty, generally one to six months of interest payments. If so, you may be able to get this waived if you refinance with the same lender. If not, it doesn't necessarily mean you shouldn't refinance. It's just another cost to factor into your decision.
Second, there are various closing costs that you'll have to pay upfront. These can include an application fee ($75 to $300), a loan-origination fee (can be 1.5% or more of loan principal), points (generally up to 3% of loan principal), an appraisal fee ($300 to $700), an inspection fee ($175 to $350), an attorney review/closing fee ($500 to $1,000), title search and insurance ($700 to $900), and a survey fee (up to $400). You can sometimes get "no-cost refinancing," but this just means that the lender will roll these costs into your loan or cover them and charge you a higher interest rate, so you'll pay them one way or another.
The good news is that you can eventually recoup these costs through lower payments. This calculator can help you figure out how long that would take so you can make sure you'll keep the home long enough for refinancing to make sense.
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Will you pay more or less in interest?
Of course, the main cost will be the interest rate you'll pay on the new mortgage. Because rates hit historic lows the week of June 21, you could get a lower rate after refinancing if you have a 30-year loan and haven't refinanced in awhile. However, if you're refinancing a recent 15-year loan, or if your credit has taken a hit, you may pay a higher rate. It could still make sense, though, depending on what you're using the extra cash for. This brings us to …
What would you do with the extra cash?
There are a couple of ways to free up money from a refinance. One is with lower monthly payments, either because the interest rate is lower or because you're extending the loan term. The other is with a cash-out refinance, in which the mortgage company writes you a check for a lump sum.
Here's how it works. Let's say your home is worth $500,000, you owe $300,000 on it, and you refinance with a new loan for $400,000. Since only $300,000 is needed to pay off your old loan, you can take the remaining $100,000 in cash.
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Keep in mind that any cash you get isn't free money. It's essentially a loan at whatever interest rate your mortgage is. While that's obvious in the case of a cash-out refinance, it can also be true whenever you extend the length of your mortgage.
So is it a good idea? That largely depends on what you do with the money. Let's take a look at some examples:
- Paying down high-interest debt. If you use a cash-out refinance to pay off credit card debt, you're probably saving a lot of interest, especially when you consider that the mortgage debt is tax-deductible. On the other hand, you're replacing unsecured debt with secured debt. In short, if you don't pay your credit card debt, your credit rating will be hurt, and there could be a small chance you'll get sued. But if you can't pay your mortgage, you could lose your home — so make sure you can afford those payments.
- Financing education expenses. One questioner wanted to use the extra money from lower payments to pay his daughter's college bills. This has less of a benefit since student loans tend to have relatively low interest rates, although not generally as low as mortgage debt. However, the refinance would reduce his risk of default since his mortgage payments would be lower, and thus easier to pay, in an emergency.
- Increasing/preserving investments. Another questioner wanted to use the savings from lower payments to contribute more to his 401(k) in the few remaining years before his retirement and then be able to withdraw less from his retirement accounts during his retirement. He would essentially be borrowing from his home to invest in his 401(k). This can work well if you're an aggressive investor and your investments perform within the historical average of 6% to 10% per year, but it also carries the risk of being stuck with additional mortgage debt, even if your investments perform poorly. The key is to make sure that you can afford your mortgage payments regardless of how your investment portfolio does.
What's your tax bracket?
As you pay down your mortgage, a greater portion of your payments goes to principal and less goes to interest. The advantage is that it gets you closer to paying off the mortgage. The disadvantage is that you get less of a tax break, since only the interest portion is deductible. Refinancing lets you restart the clock and keep a bigger tax deduction. The higher your tax bracket, the more this benefits you.
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It may be counterintuitive, but for all these reasons, continually refinancing your mortgage and never paying it off can make sense. Just make sure that you can afford the new payments, and that you'll use the savings wisely. After all, even cheap debt is debt.
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