Got this email recently:
My wife and I are looking to build in the next 2-4 years. I have a great interest rate (5% on 15) on my existing mortgage. I am considering refinancing through a local credit union, to keep closing costs low, at 5.625% on a 30 and then throwing the extra money, we save from a lower mortgage payment, into a CD (@ 4%) or a high interest checking account (@ 5%) to save for the new house.
So, what do you think of this idea?
I wouldn't do it.
I really doubt you'd come out ahead and you may very well come out behind doing this.
Lets just say for example you have and original loan of $100k and you're 5 years into it for an outstanding principal of about $74.5k. That would give you 15 year @ 5% payment of $791. If you kept paying that 15 year mortgage for 4 more years you'd pay $12,503 interest $24985 principal. That would leave you a principal balance of $49,572
If instead you refinanced today at a 30 year @ 5.625% then your payments would be $429 a month and you'd pay $16,332 in interest, $4279 principal in the next 4 years. You'd have an extra $362 a month to invest and at 5% over 48 months you'd pile up about $19.3k. So you'd have a loan balance of about $70.2k and $19.3k in the bank. If you subratct the bank balance from the debt then you're still left with about $50.9k of debt.
Your exact situation will depend on the balance of the loan and how far you are into it.
Key reasons I wouldn't do this are
1) you're paying an extra 0.625% interest on a home loan. That is not a lot of interest but if your loan is $100k principal still then thats $625 in a year. You'd need over $12k in the bank to make $625 interest at 5%.
2) Closing costs on the new loan. Closing is often a few thousand bucks.
You can run the numbers yourself by finding a mortgage calculator and looking at the month by month payments for principal and interest.
Jim
Posted by: Jim | October 20, 2008 at 04:24 PM
Oh, one point, I didn't take into account the tax impact. But I figure that you'd get a tax break on the mortgage interest but you'd have to pay taxes on bank savings so its almost a wash tax wise.
Jim
Posted by: Jim | October 20, 2008 at 04:25 PM
I agree with Jim. I did calculations on a $200k mortgage assuming you were 3 years in. After 2 more years you will owe $149,100 on a $250k house (for example), equalling $100,900 after the sale.
If you refinance, you will owe $166,500 for $83,600 profit after sale, plus $14,400 in the bank (~600/mo at 5%, but only if rates stay the same). So in this case, you're only $98,000 ahead. This does not take into consideration any closing costs or decline in market rates, not to mention the hassle of refinancing. I looked into refinancing to save 1% but the application process was so involved I didn't think it was worth it. You're better off saving extra money separately or else paying down the principal on your existing mortgage.
Posted by: LC | October 20, 2008 at 04:39 PM
This is the kind of risky logic that spawned interest-only loans, forty-year amortization schedules, and the like. Why not an option ARM with a lower interest rate, 30 year amortization, and 5 year balloon? Sound familiar? When you buy your next house, will you plan on paying as little as possible on the principal while you "save" for the next house after that?
Posted by: Mr. ToughMoneyLove | October 20, 2008 at 05:10 PM
I wouldn't go through the hassle... It doesn't seem worth it. Who knows where the interest rates will go anyway, they are at about 3.25 right now but could go lower.
Posted by: Emily | October 20, 2008 at 06:59 PM
What are they trying to accomplish with the refi, other than saving a small amount per month? I assume they currently live in a house and want to build a new house on a different piece of land in 2-4 years, and intend to move there.
If they intend to keep their current place as a rental, I suppose a refi makes some sense as it makes it easier for the rental to be cashflow-positive. If they intend to sell when they get their build done, the refi doesn't make much sense. If they need extra cash to do their build, they could use a HELOC as a bridge loan when they're ready to do it. Since they're paying down their 15 year note quickly, they'll have decent equity if the market doesn't tank much further. Refi-ing into a 30 year fixed will mean they'll have a bit more cash in the bank, but far less equity in the house.
Or they could get a construction loan on their new place and have it convert into a normal mortgage when they're done with the build.
Posted by: Foobarista | October 20, 2008 at 08:52 PM
We are building up for a larger down payment on our next home, which we will buy in 3-5 years, simply by paying down as much extra as possible on our current mortgage. It's a guaranteed 6.20% return and we don't have the added costs of an unneeded refi. Just build equity in your place and use that equity as your down payment since you shouldn't be buying a new house before you sell your current place anyway.
Posted by: mrm | October 20, 2008 at 10:04 PM
I'd like to know where you are getting 5.625% on a 30 year. Are you sure?
Posted by: Tim | October 21, 2008 at 08:42 AM
Thanks for the answers guys! You are right that we would be building on land that we already own. I see the flaw in my thinking, thanks for helping a guy out!
5.625% is a quote from a local credit union. As of today it is 5.875%
Thanks again.
Posted by: J.M. | October 21, 2008 at 09:23 AM
Tim - I don't think that's too unrealistic of a rate. My credit union was offering 4.875 on 15 yr (they didn't offer 30 yr), so you can really get good rates if you shop around.
Posted by: LC | October 21, 2008 at 09:42 AM
J.M., I know I'm late to the party but I would never go from a 15-year mortgage to a 30-year one. The key to financial independence is eliminating all debt, but in this case you would just be adding more debt and for a longer period, too.
Posted by: Todd | October 21, 2008 at 12:16 PM
LC:
What Credit Union? Can I join?
Posted by: Tim | October 21, 2008 at 02:35 PM