With mortgage interest rates so low, one of the most frequent questions I’m asked is “should I refinance my mortgage?” In most cases, once I review the individual’s circumstances, my answer is no. That’s not to say I recommend keeping their current mortgage, but rather I suggest there might be a better alternative. And that alternative is paying off, or at least paying down, the current mortgage. Let’s explore.
A hypothetical client has a $200,000, 30 year fixed mortgage at a six percent annual interest rate. By going to Bankrate.com I found a rate of 4.875. Availing himself of this rate would offer the client an annual reduction of 1.125 percent, which is not too shabby in my book. Unfortunately, the APR (annual percentage rate) comes out to be a bit higher at 5.112 percent annually.
The difference comes down to the “F” word… fees. The bank charges a two percent origination fee (which amounts to $4,000) and additional closing costs of $1,319. The total bill is now $5,319, or an additional 2.66% on a $200,000 loan.
Mortgage brokers will be quick to assure borrowers that they shouldn’t worry about these fees, because they can build them into the loan. In other words, you end up borrowing $205,319. I’ve even heard mortgage brokers claim this was a no cost loan, though it’s anything but considering you also pay interest on the extra amount you borrow.
It’s still not bad because you’ll break even after only two years and four months. So, as long as you intend to keep the house this long, you’ll end up better off than if you had kept the mortgage.
Let’s pretend this mortgage is free
“Free” is one of my favorite words so let’s take a trip to Fantasy Island and say this mortgage has no closing costs whatsoever. This means the client would be able to get this loan without costs and would start saving 1.125 percent from day one. My advice might still be against taking it.
Say the client had a $500,000 portfolio that was invested 60 percent in stocks and 40 percent in bonds. This translates to having $200,000 in bonds which, may I add, is no coincidence. I’m a believer that bonds should be the shock absorber of a portfolio so I recommend bond funds like the Vanguard Total Bond Fund. This fund is comprised of U.S. government and investment grade bonds yielding 4.01 percent as of June 28, 2009.
Of course you could always earn more with funds like the Oppenheimer Core Bond Fund which Morningstar shows as having an 8.38 percent trailing annual return. Keep in mind, however, that the Vanguard Total Bond fund earned 5.1 percent in 2008, while the Oppenheimer fund lost 36.2 percent, or nearly the same as the U.S. stock market.
The point is that one should compare a mortgage against a low to no risk bond, since the increase or decrease on the value of your home is not in the least dependent upon how you finance it. So my advice to this client would be to either pay off the mortgage, or take out the new $200,000 mortgage at 4.875 percent, keeping this same amount in the Vanguard Total Bond Fund earning 4.01 percent. In doing so, they could essentially become their own banker and earn 4.875 percent by paying off the mortgage.
Quite often I get a response noting that the mortgage is tax-deductible so it’s really costing them far less. This is true, but omits the fact that the bond fund is taxable so they really are comparable.
My advice
Think of paying down the mortgage as investing in a risk-free bond that is likely paying more than you could get on an equivalent risk-free investment. If you’re wondering why you haven’t been advised of this before, it’s likely because practically no one has the incentive to tell you. Mortgage brokers want the commission on a loan and financial planners usually charge on a percentage of the funds they manage or commission. Pay off the mortgage, and you cut out the profits of the middlemen.
