BY GREG MERMEL, C.P.A.
As a general rule, I am not one who follows the herd. I do not readily
accept the conventional wisdom in many situations, and tend to be skeptical
about following financial fashions. By the time the broad American public
hears about a once-good idea and jumps on it, the idea is diluted and
stale. But there is one current trend I can wholeheartedly endorse. Refinance
your mortgage. If it is more than a couple of years old, you will save
significant money.
Be prepared for some delays, because everyone else is doing it. According
to a trade group, the Mortgage Bankers’ Association of America, a
stunning 76 percent of the mortgage applications during the week ending
May 16 were refinancings, and the overall volume of applications had increased
by 196 percent from the year before. Try as they might, mortgage originators
have trouble keeping up, and the time from application to closing is slowly
stretching out.
Why the Mass Is Right
Interest rates, as you have probably noticed, are lower than they have
been in many years—30, 40, even 50 years, depending on which benchmark
and expert you cite—and there is not much farther down they can go.
Granted, many people thought that a year ago, yet according to Freddie
Mac (a federally-chartered company funding mortgages), the average rate
for a 30-year mortgage for the week ending May 23, 2003, was 5.34 percent,
compared with 6.81 percent a year ago.
Interest rates in the United States are partially set by the Federal Reserve
Board, and partially by market forces. To the extent they can be controlled,
the Federal Reserve uses changes in interest rates to stimulate the economy
when it is down, or to slow it when it becomes overheated. This use of
monetary policy (as it is called) has its limits. The high-dollar amount,
low-risk interbank rates set by the Federal Reserve are perilously close
to zero. To go much, if any, lower is likely to be ineffective as stimulus,
and have the potential for starting deflation. If we are not at the bottom,
I think we are close enough as to make no difference. And if I’m
wrong about that, maybe you’ll refinance again in a year.
The Numbers
The process of applying for, and receiving, a mortgage is tedious at best
and exasperating at worst. Is it really worth your while? Consider these
figures, all based on a 30-year fixed rate mortgage of $150,000. At 5.34
percent interest, the monthly principal and interest payment is $837.
Compare that with $979 for the year-ago rate of 6.81 percent. Mortgage
refinancings from a reputable lender in the Chicago area typically cost
about $1,500. That means the cost of refinancing a year-old mortgage can
be recouped in about 10.5 months, and you are $1,706 per year ahead for
the following 29 years. Freddie Mac statistics show the average rate was
7.2 percent two years ago, and 8.62 percent three years ago. Refinancing
that two-year-old mortgage recovers its cost in about 8.25 months, with
annual savings of $2,178; the three-year-old mortgage, 4.5 months and
$3,954 per year. For that kind of money, I think you can manage to be
patient with the process.
What Has Changed
During the boom, I saw many people refinancing mortgages to take out cash
from the ever-increasing value of their homes. Sometimes the additional
money was used to fix up the house, or help finance the purchase of a
second home. Sadly, I also sometimes saw it being used to pay off credit
card debt, or, worse, to invest in those fabulous technology stocks that
were sure to make the investor rich. I am seeing much less of that now,
and appropriately so. Real estate prices have held up, and even continued
increasing, during the economic slowdown mostly because low interest rates
have made buying more affordable for many people who would otherwise rent.
When interest rates start back up, this will reverse; housing values will
stagnate, and might go down depending on what else is happening in the
economy. One should not risk being “under water” on a home loan,
that is, owing more than the house is worth. Consider taking cash out
if you must to pay off other debts, but otherwise proceed with caution.
But I’m Already Five Years Into This Loan
Some folks object to refinancing a loan that they have been paying on
for a few years because that “just means I’ll be paying longer.”
That presumes they are going to replace the loan on which they have, perhaps,
25 years left with a new 30-year note. A 30-year mortgage is the commonly
quoted benchmark, but it is not the only loan term available. Fixed rate
loans for 15 years have been widely available since the early 1990s, and
lenders offering 20, 25 or 10-year terms are easily found. Shorter terms
typically carry lower interest rates, too: Freddie Mac quotes the current
rate for a 15-year loan at 4.73 percent.
The real savings comes from reducing the interest rate. Freddie Mac’s
statistics show the average rate for a 30-year loan five years ago was
7.92 percent. On a $150,000 loan, that payment would be $1,092 per month,
and the principal balance after five years would be $142,500. Refinance
that over 25 years at 5.31percent, and the payment drops to $862 per month;
the cost of refinancing is recouped in 6.5 months.
For those who truly look forward to owning their present home debt-free,
lowering the interest rate can dramatically shorten the time to pay off
the mortgage at virtually the same payment. Refinancing the same $142,500
loan for 15 years at 4.73 percent would increase the monthly payment by
a whopping $14. Most people can afford that, and many would consider the
refinancing cost a high-return investment in their retirement fund.
Are there money or tax questions you would like to see discussed in this
column? Let me know, at 2835 N. Sheffield, Suite 311, Chicago, IL 60657,
or call 773/525-1778 (888/525-1778 toll-free outside the Chicago area)
or e-mail greg@gregmermel.com.
Greg Mermel is a certified public accountant whose clients in the arts
range from individual performers to major theatre companies and suppliers.
He also sometimes produces theatre.