Sometimes in life, you realize you have to put your money where your mouth is. To make a long story short, for a few years now, I have been a strong advocate of “term reduction” when refinancing. This may or may not come as news, but I have been. However, I also work in the Mortgage/Real Estate business and to put it mildly, we have had a bit of a rougher go of it. So I was still on a 30 year fixed.
Three big reasons have had me advocating cutting the years off a mortgage for client of mine:
– You gain control or build equity far more quickly.
– Retirement can come far earlier without a house payment to make.
– You Save Tens of thousands of dollars instead of $100 per month or so.
Let’s discuss each of these reasons in a bit of detail. They will each make sense on their own but when taken in total, they make a strong case.
Equity = Current Market Value – Mortgage Loan Balance E = (CMV-MLB)
First you gain control or build equity very quickly. It is critical to keep in mind that your equity is the difference between the amount that your property is worth and what you owe on it. You don’t have much control over the current market value at any point in time, but when you reduce the term of your mortgage, you grow your equity by reducing the mortgage loan balance!
A critical, and sometimes mistaken assumption, on the part of buyers is that your homes value will be generally rising. However, this cannot be relied on as evidenced by home values at minimum stalling out or even falling over the period of 2008-2103. This could easily be a flat, non rising market for housing for years to come if rates rise, demand falls or simply the great appreciation from 2013 to 2015 stops.
The second concern is related to retirement. You often hear financial planners, talk show hosts, magazine writers, bloggers and the like discuss how much you need to retire. They toss around rules of thumb like you need ten times your annual income saved or you can draw 4% of your assets every year without running out of money. Figure out your own numbers, but let’s use the above for this discussion.
Think about this. If you need to pay a $1500 mortgage payment monthly when you are retired, that translates to roughly a $300,000 loan today, give or take. You would then have to save $450,000 to generate the needed income, and then invest it correctly to grow to $450K. To do this, you need to save $450,000 through savings and investment WHILE continuing to keep paying a mortgage you could have gotten rid of for $300,000. This makes little sense to me.
The math part is also simple to figure. If you have a 30 year fixed rate loan around 5% you likely could save $200 per month or $2400 per year with a traditional refinance. But you spread the loan back out over 30 years., adding payments to the back end of the loan.
A 20 year loan could be roughly the same payment, surely less than a $100 increase assuming you had your 5% loan for 3-4 years. When that happens you do cut 6-7 years off the loan. So you have that certainty! The skipped payments alone would be approximately $115,000. Once you have the loan paid off, feel free to save aggressively put that money away. But you no longer need to save $450,000 in order to use it to pay mortgage payments, because you have NO MORTGAGE!
With these type of dollars at state and interest rates ridiculously low, it makes sense to refinance, but it makes the most sense to refinance to a shorter term loan and take control of your equity, your retirement and your future.
The three reasons to reduce the term of your mortgage are powerful and are always present. However, there are a couple of arguments that are traditionally thrown in the way of shortening your term. They include:
1. Reduce your monthly payment and invest the rest.
2. Taking a mortgage at todays rates, around about 4%, and investing in the market at 8, 10, 12 percent rates of return makes more sense.
3. You can always pay ahead on your mortgage anytime you want.
4. Taxes will eat you alive when you don’t have your mortgage interest tax deduction.
I will rebut these simply, based on both my own experience and the experience of my clients and the professionals that I have worked with over the years.
1. Theoretically, yes, but few take $100, $200 or more in monthly savings and immediately sign up to have that money auto drafted into their investments. Most people just use it for cash flow.
2. The math is a winner, but really few earn more than 6-7% over the long run and many buy at the wrong time as well as sell at the wrong time. Losing money/gains at every transaction that eats into long term gains.
3. Nobody does this in a systematic way. Ever. Maybe people throw an extra $1000 at the loan if a small windfall rolls in, but few people “take a 30 and pay it like a 20 or 15 year loan”.
4. No they won’t. For most people over the last ten years, interest rates have dropped to the point that the tax deduction is worth far less than it used to be. Additionally, if you earn $8000 per month, have a mortgage of $300K at 4%, you have $12,000 per year in deductible interest. That’s $1000 per month on a 25% tax bracket that is $250. Your tax bill is HUNDREDS of dollars cheaper than your mortgage payment is today. Pay the tax man and move on with your paid off house knowing that you will never be foreclosed on.
So now I have a 20 year fixed. Took my own advice and am on target to pay off my own house 7.5 years earlier while removing $109,600 in mortgage payment commitments from my world. You can check out my personal numbers in this three minute video. This math is how we help clients get ahead financially. Call me, I am happy to look at your mortgage and see if you can do the same.
