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.
- MSN Money: Should you refinance?
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.
Pay off the mortgage as soon as you can afford it. Of course, pay off higher interest debt first - such as credit cards or car loans. Make sure that you are saving a little for retirement along the way (compound interest works both ways). Have your emergency fund established so that when it rains it can be taken care of without barrowing additional money. With all that being said, remember that your house -especially your primary residence is a place that you will not be able to sell quickly if cash is needed; however, you will need to live somewhere.
Although, my house is now paid off, the mortgage was lower than what most people I know pay in rent. I am still working and will probably work for the next 20 years, but if I get laid off, I know with my emergency fund I would be alright. The point is live below your means and you will be alright.
I can tell you that remaining indebted and owing money to the bank your entire life is the best way to go. And sure while I may own bank stock and this strategy gives me a guarenteed income for life from bank dividend payments, that's not gonna really sway my opinion that this is a GREAT idea.
It is kind of sad that someone can write an article without having much knowledge even if they work for forbe or maybe they just hiding info which is even worst. Yes, it is true that by paying less in principle and more on interest you get a bigger tax break. BUT what happens to all that interest you paid.
Take the 400000 loan Erik mentions. If the interest is 3.5%, you would pay 14000 in interest!!! So now you may get 3000 dollar tax break and you are happy? really???BE YOU LOST 11000 DOLLARS!!! REALIZE THAT! AND DON'T BE SO HAPPY FOR THE 3000 DOLLAR GAIN. Erik and anyone else that can't do basic 5th grade math should never ever have such a job advise people.
I think the question is a fair one to ask as an academic exercise: do I come out ahead financially if I a) pay down my mortgage faster or b) pay it down more slowly, and invest the difference? It's not more than an exercise, as I think most people will find it difficult to find a very safe investment that gives them a return that "beats" the guaranteed return they get from paying off a mortgage faster plus the cost of each refi.
The article assumes it's easy to roll a 30-yr mortgage into a new 30-yr mortgage every 10 years. It's hard enough to get a mortgage. Try it when you're 50 years old and asking for a mortage that wouldn't be paid off until you're 80. Additionally, an equity cashout on a refi may not be fully tax-deductible. There are IRS limits on the deduction when you refi to a higher balance. If the article goes so far as to suggest cashouts, it ought to mention this fact.
If this article was written in 2005, it would have suggested getting an interest-only mortgage with a balloon payment at 30 yrs. That would give you the smallest possible monthly payment, leaving plenty of money to invest in the stock market, which always goes up. And since house prices always go up, your home equity actually improves even though you don't pay a single dollar against the principal owed. Win-win!
This is such a bad advice, and what led people to get into trouble. First, pay up your mortgage as soon as possible. If you don;t pay your mortgage, you may end up on the streets. If you don't pay your credit cards, they cannot take your home.
Second, DO NOT use your home as a cash cow. People that got into trouble with their mortgage that more than one mortgage. Often, people took equity cash to waste it on dumb things, such as cars, or vacations. Then, whined to the government for a bail out. Be RESPONSIBLE!
Some types of debt are better than others, but ALL debt has one common denominator:
Debt is like a siphon hose attached to YOUR wealth and enjoyment of life!!!!
suckers. Got my daddy like that years ago on a Cadillac.
No only a fool would get a mortgage in this day and age no matter how cheap an interest rate is.
Any banker will tell you to refinance every few years and use any "extra" to pay down higher rate loans. Of course they will tell you that. What they don't tell you is your new long term interest is worth much more to them. They are out to take as much money from you as they can. That's their job. Moreover, most folks do not have the ability to continue that "concept" and blow that money and more. Ultimately, they just build up more and more debt. I have seen it over and over again.
I paid my first house off in under 7 years by working hard and paying down the principle as fast as I could. I paid cash for my second (rental) house. I have no problems with the housing market and sleep well at night. It is nice to not have to work for years and years just to pay some fat cat a bunch of interest. I used that money to buy the rental house.
Pay off your debt. Plain and simple. Make small positive contributions to build your wealth instead of wasting your time and money on interest for the banks. You won't live like a king at first, but what you have is yours, and that security feels much better. My cost of living is very low now because I have no debt.
You will find that, ultimately, you will have much more money later.
And no, I am not rich. I work for a living. I just played it smart.
First, let's assume the ability to take a 200,000 mortgage or pay cash.
Ok, you pay cash from a shoebox, you pay no interest, and you make no interest. 0 sum game.
Next, you pay cash and start investing the $926/mo that you would have been paying if you had a mortgage. In 30 years @ 5% average compounding you have $774,000 to show. Not bad.
Next plan, you take a 200k mortgage and put that 200k cash in that same average 5% investment and add nothing else. In 30 years you have $893,000 to show and paid 133,000 interest. $760,000 net.
Factor in some tax savings and it's back to a 0 sum game. With or without a mortgage at the end of 30 years.
Now, factor in life. Factor in someone a spouse dying and the other not being able to get the equity out of the house without selling it because they don't qualify. If it was in the bank, they could have easy access without needing to qualify. Factor in someone losing a job. Ok, oh, they can't make their payments now...yes they can because they saved and have money in the bank to offset monthly payments until they get back on their feet. Factor in a house that blows away, floods, burns. Insurance companies, I hear, have a habit of dragging their feet but wheres the money, in the house or in the bank? If it's all in the house, you're at their mercy.
Point being, it's not all about paying dollars here, making a few there. If you can leverage successfully and make more than you pay, wonderful. To some financial security might be having a house paid off but for those, I bet, gave little consideration to other life events and the restrictions created when all the money is in the house. People get so focused on paying off a mortgage above all else because it is evil and it makes them 'feel' good to do so. The 15% credit card companies love them for it as their still getting their high interest. Employers with retirement matching love it..how many don't maximize their 401k at least up to where the company will match contributions? What makes me feel good, knowing that I have money in the bank that any time I want I can pay off the mortgage but also knowing it makes no sense to do so.
No puppies were harmed in writing this post.