I know a lot of people who think that your US mortgage “restarts” if you refinance. That is not true. If you are able to refinance your mortgage with a new rate just .25% a little bit lower than your current rate, the cost of refinancing can pay off within just a year!
A little bit of “Mortgage theory”
Each and every mortgage payment you make is the sum of three components:
- The interest on your total balance (balance=the amount you owe), which is exactly the interest rate you have (APR) divided by 12 (because the “A” in APR means annual, and you make 12 payments, once per month in a year). This is the what I will call the basic rule of mortgages.
- A principle payment that is exactly what is necessary to cause your mortgage, with your given the APR, to be totally paid off after the duration of your mortgage.
- If you have an “escrow account”, then there is an addition of property taxes and property insurance which is independent of the above two.
For a normal fixed-rate mortgage, the sum of 1. and 2. above will never change. Gradually, 1. will decrease and 2. will increase.
What happens when you do a refinance
Every time you make a payment, the part of your payment that goes to “principle” changes what you owe, by making it decrease a little bit. As a consequence, your costs go down if you can lower your APR. You can lower your APR by refinancing, and refinancing doesn’t change your principle; what you’ve already paid off is what you’ve paid off.
When you refinance, you, do effectively “restart your mortgage”, which is probably why the myth I’m discussing here is so stubborn! You had a 30 year mortgage, you were paying it off for 10 years, and then you refinance and you have a 30 year mortgage again. That sounds like a bad deal, but here’s what you’re missing:
- You can just get a 20 or 15 year mortgage instead of a 30 year mortgage. You could get a 15 year mortgage and maybe have a higher monthly payment, but pay off your mortgage 5 years early and save hundreds of thousands of dollars. Generally, shorter mortgages have a lower interest rate, saving you even more!
- You can get a new 30 year mortgage at a lower rate, and overpay it, making your monthly cost effectively the same, but you still pay off your mortgage years early! I’m not even sure it’s possible to get a mortgage that penalizes paying off a mortgage early.
Sometimes, people say “you pay the interest first”. This is simply not true! This is the main crux of this myth. No, you do not pay interest first! You only pay the interest on the existing balance. It just seems that way, because, per my basic rule of mortgages, when you owe more, you are paying more for interest, and as you pay off your mortgage, you owe less!
The catch: refinance fees
It costs money to do a refinance. The bank will charge you “origination fees”, they might charge you appraisal fees, in certain consumer-hostile states there might even be a refinance tax, because the banks successfully bribed your state to make those taxes so that you don’t refinance.
These fees can be thousands or 10s of thousands of dollars. But they are the only reason that it might take a year or two to “break even” after refinancing. Just subtract those fees from your savings to see the break-even duration. If that duration is less than a couple years, it’s probably a good idea to refinance, unless you expect rates to get even lower in that time (they probably won’t right now, IMO).
A note on variable rate mortgages
Variable rate mortgages are not necessarily a bad deal and may very well be a good deal. They don’t really change the formula above very much other than that the APR can (and will) change. In the interests of simplicity, I disregarded the effects of a variable rate mortgage, other than to say that most of the content of my post probably still applies.
Final notes
Shop Around! Shop around when looking for banks! Even after you have a “preapproval” letter from your bank when you are first house shopping, you can still shop around even though they say you cannot (a contract isn’t a contract until money changes hands!).
When I renewed my mortgage, from 4.25 to 2.85, I was given the option of resetting to thirty years to reduce the monthly payment.
I took the offer, on the theory I’d be better off investing the difference than paying the principle. So far, it’s paid off.
There are two things missing from that calculation. First, the mortgage savings are generally after tax, while investment gains are taxable. So the comparison of break even needs to take this into account.
Secondly, if pay off the mortgage earlier, then you have some number of years at the end where you can then invest the entirety of your payment instead of paying mortgage.
The calculation should be to compare the net effect of the taxable investment of the lower mortgage payment difference for 30 years vs the net effect of paying less total interest over 20 years, plus investing the entire mortgage payment for 10 years after the mortgage is paid off.
Otherwise, you’re not comparing apples to apples.
The last thing isn’t numbers, really. You can live in a house, you cannot live in an investment account, and you have to live somewhere. If the market crashes it takes your investments with it, but if the housing market crashes, then you can still live in your house. And if for some reason you have to sell the house, then owing less on it - guaranteed - is a good thing, no matter if the value has gone up or tanked. That does something to the risk calculation.
Not to mention the discipline bit that you mentioned. Life has a habit of getting in the way, and the decision to invest is always an open question whenever something happens. The decision to pay a higher mortgage for a shorter term is closer to firm than that.
Long term taxation on investments is 15%. So, at a 2.85 interest rate we’re still talking about 3.3% ROI. I can beat that buying a US Treasury Bond.
But you’ve foregone all the income returns in the initial years that you failed to invest in the market.
Let’s be conservative and predict a 7% market ROI (right now, the markets are doing closer to 25% YOY). If my options are $1100 mortgage payment over 25 years or $1000 over 30 years, I’m looking a 25 years of $100/mo savings ($1200/year -> 25 years = $30,000). By the time you’ve paid off your mortgage, my accrued investment returns amount to around $78k. So we’re going into year 26. I’ve got $78k in investment principle, at 7%/year, earning me $5400/year. That’s nearly half my mortgage note. You’re putting your first $1100/mo => $13,200/year into savings, having missed 25 years of compounded returns.
Up the ROI from 7% to 10% (the historical DOW return over the last 30 years), and now I’ve got $123k in principle, earning $12,300/year, which is more than the mortgage note.
The excess you’re paying into the mortgage is effectively an investment with a yield equal to your interest rate. If you were paying an 11% note, getting rid of your mortgage quickly makes sense. But at 3%, it does not.
The raw math becomes ($mortgage payment)(ROI - Interest Rate) = Implicit Return.
In both scenarios, we’re living in the house. The amount you pay on the note doesn’t change that.
That’s where the math ultimately gets fuzzy. Are you actually banking the $100/mo in mortgage savings as investment? Or are you just shoving it in your savings account and forgetting about it? Or spending it?
I find that periodic automatic transfers do a lot of this book-keeping for me. 401ks come out of my paycheck before it hits my savings account. I’ve got an automatic monthly deduction for my son’s 529 and my Roth IRA. And I try to do a sweep from my savings to investments roughly once a month, when I’m over a certain cash balance.
But I’ll concede all this requires a certain surplus income. If you’re stuck living paycheck to paycheck, its possible that paying down the mortgage faster is just less of a headache than juggling balances to make sure ends meet.
I’m in Canada, not the US, so some of the practices are strange to me. But Google tells me that a typical rate for size of mortgage in your example is 6.6%, not 2.85%.
Just for shits and giggles, I ran this past Google Gemini to crunch the numbers. A 250,000 mortgage at going rates for 25 and 30 years with the difference invested for 30 years vs investing the entire payment amount for 5 years after paying off a 25 year mortgage. And accounting for taxes.
Basically, they tie at a 9% RoR, and the longer mortgage wins by 25K at 10%. But let’s also remember that is future dollars, with a PV of about $11K.
Also of note, the 25 year mortgage has a slightly lower rate than the 30. That impacts the result a bit.
Today, certainly. Back in 2020 when we were entering the COVID-induced recession, the prime rate plunged back into ZIRP territory and you could refinance a mortgage incredibly cheaply.
Generally speaking, your options are 15 year or 30 year (at least in the US). The difference in interest rates is typically marginal, though. Maybe .5 pt, from what I’ve seen. The real perceived benefit is paying off the debt faster. But… again, if the loan is large and the interest rate is small, you’re putting a lot of cash behind a comparatively low return.
What are yoy talking about, life is a spreadsheet. Sort by Column J and do the one at the top.
Really!
I’m shocked that investing the difference actually worked out better for you. Everyone is always talking about paying off your debt first.
It’s literally as simple as deciding if you can earn more than the interest rate of your mortgage. Even a savings account at 3% interest beats a mortgage at 2.75%, dollar for dollar.
The hard part is having the discipline to not spend the money.
Getting above a 2.85% return is pretty trivial.
Paying off your high interest debt is a priority, because it’s very hard to find anything that’ll get you Credit Card Interest levels of return. We scrambled to pay down our student debt, which was in the 7-8% range. Maybe not the best move, but it was a conservative decision. If you’re into the double digits, definitely get rid of that ASAP.