Mortgage

Reasons Why You Should Not Refinance Your Mortgage

Being the summer of 2009, and with the mortgage interest rates so low, one of the most frequent questions being asked by homeowners is "Should I refinance my mortgage?" In most cases, the answer has to be no! That's not to say keeping your current mortgage is best, but there just might be a better alternative. And that alternative is paying off, or at least paying down, the current mortgage.

Let's consider this scenario.

As an example, a client has a $200,000, 30 year fixed mortgage at a 6% annual interest rate. By going to Bankrate.com a rate of 4.875% was found. Availing himself of this rate would offer the client an annual reduction of 1.125%, which is a savings of around $140 a month, or $1680 a year. Unfortunately, the APR (annual percentage rate) comes out to be a bit higher at 5.112% annually and thus the monthly mortgage payment would be slightly higher.

The difference comes down to the fees being added in. The bank charges a two percent origination fee (which amounts to $4,000) and additional closing costs of $1,319. The total cost is now $5,319, or an additional 2.66% on a $200,000 loan. These fees obviously need to be considered to see if you should actually refinance.

Some 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. Some mortgage brokers claim this is a no cost loan, though it's anything but, considering you also pay interest on the extra amount you borrow. Don't be fooled by some of these mortgage brokers. Could be just like car salesmen in disguise.

Given this scenario, 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 financially than if you had remained at the 6% interest rate.

Let's pretend this mortgage is free

"Free" is a favorite word for many of us, 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% from day one. This may still not be the way to go.

Say the client had a $500,000 portfolio that was invested 60% in stocks and 40% in bonds. This translates to having $200,000 in bonds, which is no coincidence. Some people and those who run the mutual fund companies believe that bonds should be the shock absorber of a portfolio. Take a look at bond funds like the Vanguard Total Bond Fund. This fund is comprised of U.S. government and investment grade bonds yielding 4.01% 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% trailing annual return. Keep in mind, however, that the Vanguard Total Bond fund earned 5.1% in 2008, while the Oppenheimer fund lost 36.2%, 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%, keeping this same amount in the Vanguard Total Bond Fund earning 4.01%.

Even though the mortgage interest is tax-deductible, you must be aware of the fact that the bond fund is also taxable. So, in effect, they really are comparable.

In Summary

Why not take into account the paying down of the mortgage as investing in a risk-free bond that is likely paying a higher return on your money than you could get on an equivalent risk-free investment? Advice like this is rarely given, and no wonder. Everyone wants a piece of the pie! Practically no one has the incentive to tell you this fact. Mortgage brokers want their commission on the loan and financial planners usually charge on either a commission or a percentage basis on the funds they manage. Pay off the mortgage, and the middlemen all but disappear.