30 year loan still the best choice

Nov 4, 2010

Long term mortgage interest rates are at levels that have not been seen in more than 50 years.  Here are two questions that I am currently being asked frequently:

1.    Is refinancing into a 15-year loan a better choice than refinancing into a 30- year loan?

2.    Does it make sense to refinance into a new 30-year loan and overpay it simply by continuing to make the old (and higher) payment?

As with most financial questions, the answer is that it depends on your tax situation and you should speak with a financial planner to know how this issue affects you specifically. On the surface, paying off your mortgage more quickly might seem like a very wise thing to do. However, because your mortgage payment consists of principal and interest, you could end up costing yourself money. Here’s why:  interest is tax-deductible and principal is not. With a 15-year loan, more of your payment goes to principal and you end up with a smaller tax deduction. As a result, the 15-year loan will cause you to make larger monthly mortgage payments while giving you a smaller tax deduction. If you have other debt with higher interest rates, it is better to pay off the higher interest rate debt first. The bottom line is that mortgage rates are so low right now you may want to capitalize on the opportunities.

Moreover, you can save thousands of dollars with a 30-year loan. First, when considering refinancing into a shorter term loan or overpaying a mortgage, you must remember to factor in your effective percentage rate, or your interest cost after your tax deduction. It is a relatively simple calculation. Take the face interest rate of the mortgage, multiply it by your marginal tax bracket, federal and state, and then subtract that number from the face interest rate, and you will have your effective percentage rate:  e.g. 4.000% interest rate x 32% tax bracket = 1.280%.  4.000% – 1.280% = 2.720%.  In this example, overpaying your loan to shorten the term will earn you a rate of return of 2.720% since you are saving money at that rate.

Another way to look at it is that your money may not be working as hard for you as it could be if you overpay your mortgage or obtain a 15-year loan. With the example sited above, you are earning 2.720% on your money. Could you put that money to better use elsewhere? Obviously, you need to consider your personal balance sheet, your retirement goals, and consult with a professional to make the wisest decision. As a general rule, paying off debts that do not have a tax benefit attached to them (i.e., car loans, credit cards, certain revolving lines of credit, etc.) that have higher interest rates, will insure that your money is working harder for you. More importantly, by investing the money you are not required to pay on your mortgage, you could free up cash for other investments. After 15 years, by investing the added monthly savings, you’ll probably have enough to pay off the remaining balance of the 30-year loan with money left over. Let’s not kid ourselves, all of these things require a lot of saving and investing discipline.

Mortgages give you the opportunity to leverage your money. A mortgage is nothing more than a financial tool. When used properly, it can serve you well. Of course, if one misuses that tool, there can be serious consequences. The bottom line is that, if you get the right kind of mortgage and use it properly, in the context of one’s broader financial planning objectives, you can make your money work for you.

Christian Durland

Cherry Creek Mortgage



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