Rates Are Historically Low, but Likely Going Higher
By JONATHAN CLEMENTS
Is the mortgage-refinancing opportunity of a lifetime slipping away? I suspect the answer is "yes"—and it isn't because I can forecast interest rates. Rather, the Federal Reserve has announced it's cutting back on its bond purchases, and that will likely mean higher interest rates—including rates on new mortgages.
"Interest rates are no longer at 60-year lows," notes Keith Gumbinger, a vice president with HSH.com, a mortgage-information provider. "We got as low as 3.44% for a 30-year conforming loan in December 2012. We're above those historic lows by almost a full percentage point, but rates are still very favorable."
To make refinancing worthwhile, you typically need to shave your mortgage rate by at least a full percentage point. With 30-year loans available today at around 4.4%, you may not achieve that sort of savings by swapping your old 30-year fixed-rate mortgage for a new one. But you might get there by refinancing with a 15-year mortgage, which will charge around 3.5%. Or you could opt for a hybrid mortgage that is fixed for, say, the first five years and adjusts every year thereafter. A 5/1 hybrid, with an initial interest rate today of around 3.1%, might appeal to those who plan to move in the next five years or so.
Mr. Gumbinger adds that, if you couldn't refinance before, you might qualify now. For instance, if you had been out of work but recently found a job, lenders might look more kindly on you. In addition, you might have more home equity, thanks to rising home prices, and that could also help your application.
Intrigued? If you decide to refinance, keep these two issues in mind:
Do the math right. Suppose you've had your current 30-year, fixed-rate mortgage for 10 years. If you refinance with another 30-year mortgage, you will lower your monthly payment.
But that's no surprise: You're taking what is now effectively a 20-year loan and replacing it with a 30-year mortgage, so you are spreading the repayment of the current loan balance over an additional 10 years. That'll lower your monthly payment, even if the rate on the two mortgages is exactly the same, but it will also mean an additional 10 years of indentured servitude to your mortgage lender.
What to do? In the example above, you should compare your current monthly payment to the payment on a hypothetical 20-year mortgage at current interest rates. You can do that using one of the many online mortgage calculators. That will tell you how much refinancing will truly save you each month.
Now that you know your potential monthly savings, you can calculate how long it will take to recoup the cost of refinancing. For instance, if you pay $4,000 to refinance and you'll save $175 a month thereafter, you should break even after 23 months.
Aim to retire debt-free. This doesn't necessarily mean you should apply for a 20-year mortgage. Instead, I would focus on what it'll take to retire debt-free.
Unfortunately, that's a goal many folks seem to have shelved. According to the Federal Reserve's 2010 Survey of Consumer Finances (the most recent published), 40.5% of households headed by a 65- to 74-year-old had a mortgage on their primary residence.
But retiring with a mortgage simply isn't a good idea. Why not? Those monthly payments will add substantially to your retirement expenses, leaving you with less money for everything else. Moreover, to cover the mortgage, you might be forced to sell stock-market winners or make larger retirement-account withdrawals, both of which would boost your taxable income. That increased taxable income could, in turn, trigger taxes on your Social Security retirement benefit. In effect, paying the mortgage could lead to a double tax hit.
To be sure, you might offset some of that taxable income with your tax-deductible mortgage interest. Problem is, if you're fairly far along in paying your mortgage, much of your monthly payment is likely going toward principal, so you don't have much mortgage interest to deduct—and you may even be claiming the standard deduction.
My advice: When you refinance, tailor your mortgage's length to no later than your expected retirement date. What if that means hefty monthly payments that you might struggle to service? You could give yourself more financial breathing room by taking out a longer mortgage, but then aim to get the loan paid off earlier by making extra principal payments.