The Planner's Perspective: Consider All Options Before Refinancing

By Paul Morrone CFP®, CPA/PFS, MSA

Paying of the mortgage is one financial goal that many strive to achieve prior to retirement. Over a lifetime, it’s not uncommon for people to move multiple times, refinance their debt or use their home equity to fund large expenditures, including home renovation or college tuition. With lenders eagerly trying to earn your business in a very competitive lending environment, it may be difficult to determine the best way to pay off your debt the quickest. Before getting seduced by a quick refi or debt consolidation plan, run the numbers and weigh the current and future costs of all scenarios before entering into a new loan agreement. While there is no one-size-fits-all approach, careful attention to detail can have a huge impact on future cash flows, interest costs and your resulting net worth. I found this example to be eye opening as the results were not what I expected.

Here’s the case: Mr. and Mrs. Jones have a $400,000 house and have 25 years/$275k left on their mortgage (fixed @3.625%). Their current monthly payment is $1,415 principal and interest. They want to be debt free in 20 years which coincides with their anticipated retirement dates.

• Scenario 1: Continue payments along the traditional mortgage schedule for the next 25 years. Unfortunately, this does not help Mr. and Mrs. Jones achieve their goal and has not been deemed to be a viable solution.
• Scenario 2: Refinance the mortgage. After evaluating the cash flow impact, Mr. and Mrs. Jones realize that they cannot afford to refinance to a 15-year mortgage due to the large increase in monthly payment. However, they determine that they can refinance to a 20-year mortgage which would change their payment to $1,740, a modest increase of $325 (fixed @4.5%) over their current payment of $1,415. The marginally higher monthly payment is reasonable given their current and future projected cash flow. Under this case, they will meet their long-term goal by paying off the house in 20 years, and everyone is happy.
• Scenario 3: Before Mr. and Mrs. Jones sign the 20-year refinance, they should be evaluating a third option – keeping the original mortgage and making additional principal payments each month (assuming no prepayment penalties, of course). They have already determined that they can afford an additional $325/month, which would allow them to increase their current payment from $1,415 to $1,740 (same as 20-year refinance). However, because of the competitive interest rate on their original mortgage as opposed to the refinance (3.625% vs 4.5%) and the resulting amortization with the additional payments, their mortgage would be paid off in only 18 years. It would also reduce the amount of total interest paid over the life of the loan by over $40,000 (compared to refinancing over 20 years). Given the favorable financial impact and shortened duration of time that it would take Mr. and Mrs. Jones to pay off the debt, this proves to be the most viable solution under this fact set.

Additionally, there is no cost to do this (refinancing usually involves closing costs and recording fees) and there are no credit inquiries, home appraisals or documents to sign. It is also important to note that by retaining the original note, the required monthly payment will remain at $1,415. If there are cash flow issues in the future, Mr. and Mrs. Jones could opt not to make the additional principal payments rather than fall behind.