When to Trade In Your Mortgage

When to Trade in Your Mortgage

The right answer may be a lot sooner than you think. Here’s why:

The conventional wisdom is that interest rates have to drop to make refinancing attractive. The conventional wisdom may be wrong.

In fact, if you are planning to live in your house for many years, refinancing to a lower rate by as little as 1 percent may be profitable.

For a typical mortgage that involves refinancing costs of 1 percent of the total loan, accounting firms figure that, if you can lower your interest rate by a single percentage point, the new loan will put you ahead after just 18 months.

Refinancing can give you other opportunities, like switching from a 30-year fixed mortgage to 15 years. The switch usually will bump up your monthly payments, but it will also reduce the overall cost of your loan, and the interest rate you pay will generally be about a half percentage point lower than a 20-year mortgage. Another advantage: You build up more equity in your home that you can tap into later. Recent figures show that a third of the holders of 20-year mortgages choose 15-year loans when they refinance.

They may not necessarily be making the right choice, though. Consider the following example: if you get a $150,000, 30-year mortgage at 7.3 percent, you will pay $229,208 in interest over the life of the loan. A 15-year mortgage at 6.8 percent would cost less than half that – $89,612. The difference in monthly payments is $304 – $1,028 for the 30-year mortgage versus $1,332 for the 15-year mortgage.

Club marin of Montreal. Photo by Elena.

But suppose you opt for the 30-year loan and invest the $304 difference in the stock market, where it earns 7 percent after tax. (The historic return on stocks is about 10 percent before taxes). And suppose you also invest the extra tax savings generated by the longer-term loan.

Since the loan amortizes more slowly than a 15-year mortgage, more of your monthly payment is tax-deductible interest. After 10 years, the 30-year loan looks like a better and better deal. By the end of 15 years, the holder of the 30-year loan would have earn enough on his investment to pay off the remaining debt on the house and still have some $10,000 left.

Once you choose a mortgage, you`ll have to decide about refinancing costs. You`ll have the choice of covering them at the outset by paying points or spreading them over the life of the loan by accepting a somewhat higher interest rate. In most cases, you should opt for not paying points. By investing the money you would have paid in points, you can build up a tidy nest egg over the life of your mortgage, which should amount to more than you`d save if you paid the points and invested the amount you saved in lower interest costs on your loan.

The bottom line, everything considered, the best mortgage for you will be the one whose term most closely matches the time you expect to keep your house.

Your monthly payments (principal and interests) will be assuming different interest rates and loan terms.