If you’re thinking about a 20-year or 15-year mortgage, read this
Hi, it’s Hilary, and last week I shared some of the pros and cons of paying off your mortgage early.
(If you missed last week’s, you can find it here)
Again, if you have other outstanding debt – credit cards, student loans, car loans, HELOC – you may want to think twice before paying off your mortgage first.
These types of debts typically come with a much higher interest rate than a mortgage does. Higher interest debts should probably be a higher priority to pay off than your mortgage.
That said, if you’re seriously considering refinancing from a 30-year mortgage to either a 20-year or 15-year term, there are some details you need to understand.
There is a common misconception that refinancing into a shorter loan term is always an effective way to pay down your mortgage faster with less interest incurred.
And, it’s true that most lenders offer slightly lower rates on these shorter term loans – you might get an eighth or a quarter of a point lower rate.
That said, there can be significant costs associated with refinancing that shouldn’t be ignored.
First, there are the direct costs of the refinance – these are typically 1% of the loan amount or more.
I can’t tell you the number of times someone has said to me they got their refinance ‘for free’. Of course, no one works for free, and underwriting mortgages takes time. In all probability, the loan officer just increased the loan amount and inserted the costs of the refinance into the loan itself.
Please, always remember: Nothing is free!
Also, it likely makes sense to you that if you’re 10 years into a 30-year loan and you refinance into another 30-year loan, you’re signing up for an extra decade of payments.
It might be tempting to think that a shorter term loan would solve this problem, but that’s not always true (and most people don’t understand this).
If you’re 10 years into a 30-year loan and you refinance into a 20-year or 15-year loan, you completely give up the progress you’ve made on your amortization schedule.
This is what determines the portion of your monthly payment that goes toward interest versus principal.
When you first take out your mortgage, whether it’s at the time you purchased the home or you’ve just refinanced, nearly your entire payment goes to pay interest.
The actual amount you’ve borrowed is only declining a small amount each time you make that big payment.
Instead, you can just make extra payments or pay more than your monthly payment, and ask the lender to direct your extra payments to the principal of the loan.
Yes, you actually have to call and make sure they’re doing that, otherwise they might just use your extra dollars to pay down interest, which doesn’t get your loan paid faster.
If you want to go one step further, you can ask the lender to ‘recast’ the loan, which means they move you forward on the amortization schedule.
This has the effect of moving you closer to that finish line of being free from mortgage debt.
Plus, not refinancing into a shorter term mortgage leaves you with the flexibility to make that smaller payment if you lose your job or simply want to direct the funds elsewhere for a few months. And I love having options!
I meet plenty of people who have a big personal goal of paying off their mortgage. Many people consider it to be the ultimate in personal fiscal conservatism, and I do understand!
However, the opportunity we discussed in last week’s Profit Boss® Weekly shouldn’t be ignored. This is where you can borrow money from the bank at a very low mortgage interest rate and potentially save and invest it at higher rates – and the technical finance term for this is arbitrage.
Because of this, I rarely recommend people actually follow through on a goal of completely paying off their mortgage or refinancing into a shorter term mortgage.
Be wise with your money decisions, have a good, detailed plan, and do what best fits into your short and long-term personal and financial goals. Remember, money is there to empower your life, not rule it.
To your prosperity,
P.S. – Being free from your mortgage isn’t a guarantee of future financial success, especially if you’re a business owner. We recommend following the Profit First approach to generating and keeping more profits in your business. Learn more about Profit First here.