There's just one small catch, the reader said. He'd like to figure out the smartest way to pay off his mortgage completely. Being mortgage-free or within five years of paying it off is one of the five pillars of a happy retirement.
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Let’s call our new friend Re-Fi Ralph. Here’s his mortgage dilemma.
Ralph is 52 years old. He refinanced his home around several years ago. He wanted to know how to handle the following questions:
Re-Fi Ralph is six to seven years into a 30-year mortgage at an interest rate of 4.25%. The house is valued at approximately $400,000, and there’s about $275,000 remaining on the loan. His current principal and interest payment is about $1,475 a month, give or take. Ralph wanted to know if he should refinance to a 15-year mortgage to get him closer to his goal of having his home paid in full.
He also asked whether refinancing would just restart the clock on paying interest again. And is there a formula for riding out a mortgage and simply making extra payments, versus refinancing for a shorter term?
Before we dig in, I want to point out that mortgage calculations are complex and dependent on a host of variables. Your credit, interest rate movements, the mortgage provider, closing costs, and your income and cash flow realities all play a role. Our scenario is intended to be but one example, tailored for Ralph.
Because this is a fairly common situation folks encounter, however, the following story could help you think through your similar mortgage question. Just keep in mind that ultimately, you’ll have to run your precise numbers with a mortgage adviser and see what works best for your unique situation.
Now, back to Re-Fi Ralph. These are the key variables he needs to consider:
1. His current interest rate versus his new rate.
2. The number of years in the new term (30 years or 15 years).
3. Whether he wants to make extra monthly principal payments at his discretion or have a higher monthly payment for a shorter-term mortgage.
While closing costs are another variable to consider when talking mortgages, our article will keep the focus on saving on your cumulative mortgage payments over the life of the loan.
Remember that a lower monthly mortgage bill is not the goal here. Ralph’s question has to do with paying less over the life of the loan. His questions get to the root of the total cost, not just those checks he’s writing each month to his lender.
Herein lies the dilemma: Should Ralph refinance to a shorter mortgage or make extra principal payments? Which strategy will result in the most significant savings?
There are three ways Re-Fi Ralph can accomplish his goal. Let’s walk through each of them.
1. Pay the balance off today. Problem solved! Poof – no more interest. For this scenario to work, I would use my one-third after-tax money rule. This rule states that if you can pay off your full mortgage balance with after-tax savings (meaning without tapping your retirement funds) and you can do it with a third or less of your liquid capital, then you should do so. However, Ralph is like most Americans and has the bulk of his wealth in his 401(k) and IRA assets. At 52, he's too young to begin making withdrawals from these, so taxes and penalties would apply if he did dip in. So, we'll move on to the next option.
2. Shift to a 15-year loan with a lower rate. Say Ralph could refinance into a 15-year (low or zero closing cost) mortgage at 3.125%. His monthly payment would go up by approximately $440 a month. So, his housing budget line item would go from $1,475 per month to $1,915 per month for principal and interest.
The total principal and interest Ralph would pay over the life of the new loan would be just under $345,000. If you lump in what he’s already spent over the first several years of the loan — about $125,000 — then the total amount for the new 15-year mortgage plus what he has already paid would be close to $470,000.
Let’s now compare this amount to a scenario where Ralph chooses not to refinance. Instead, he decides to increase his principal payments to shorten the life of the loan to meet his 15-year goal.
3. Stay with the original loan and make extra monthly principal payments. Ralph would need to contribute an additional $600 to his monthly payment of $1,475 to get rid of the existing balance in 15 years. In this case, the amount becomes $2,075 each month. Over the life of the loan, this approach would cumulatively cost Ralph a little over $495,000. This figure is about $25,000 more than the shorter refinance, from $470,000 up to $495,000.
The final verdict for Re-Fi Ralph is that our second scenario makes the most financial sense for his circumstances — to the tune of about $25,000. Plus, he saves on his monthly mortgage payment at the same time by choosing this option. It’s a win-win.
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Are you in Re-Fi Ralph’s shoes? Are you considering the best way to pay off your mortgage faster?
In most cases, if you can save half of a percentage point or more on your interest rate and have 20-plus years left on your loan, then it’s worth considering a refinance to a 15-year term. A lower rate plus fewer years is likely worth the effort. If you already have a relatively low interest rate and a refinance would save you less than half of a percentage point, however, then it may be a better idea to simply increase your monthly payments toward the principal and create a DIY shorter mortgage.
Wes Moss has been the host of “Money Matters” on News 95.5 and AM 750 WSB in Atlanta for more than seven years now, and he does a live show from 9-11 a.m. Sundays. He is the chief investment strategist for Atlanta-based Capital Investment Advisors. For more information, go to wesmoss.com.
This information is provided to you as a resource for informational purposes only and should not be viewed as investment advice or recommendations. This information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. This information is not intended to, and should not, form a primary basis for any investment decision that you may make. Always consult your own legal, tax, or investment adviser before making any investment/tax/estate/financial planning considerations or decisions.