BY Greg Mermel, C.P.A.
In the ill wind of today’s economy, the good blowing about is low
interest rates. That is not welcome news if you are an investor looking
for alternatives to crumbling stock prices. But if you are looking to
buy a home or refinance an existing mortgage, you have a great opportunity.
My own home remodeling is, finally, coming to an end. (The experience
will be the subject of a nasty, black-comedy play, or at least a couple
of cautionary PerformInk columns.) Rates are low enough now that
even I have been amazed at some of the deals being offered.
To Refinance, or Not to Refinance...
Should you refinance your existing mortgage? At today’s interest rates, almost anybody will cut their interest expense by refinancing. The only question is how much you save, and is it worthwhile?
I usually suggest a simple approach. How much will refinancing cost you when compared to the reduction in your monthly payment? The change in your monthly payment will depend on the amount borrowed (bigger loan, bigger savings) and the difference between the old and new interest rates. In contrast, refinancing a mortgage in Chicago typically costs around $1,500, no matter how large or small the loan. Once you know the new payment amount, divide that amount into $1,500. The result is the payback period, that is, how many months it will take to recover the cost of refinancing. If the payback period is 24 months or less, I think refinancing is worth it. Your decision criterion might be longer or shorter.
A Financial Baskin-Robbins
When I was just a wee tot, mortgage loans came in one style only. They had fixed interest rates, and were amortized over 20 years. No options, and not much competition among lenders. Today’s rate sheet from my bank lists 15-, 20- and 30-year fixed interest rate loans, and five different types of adjustable rate loans. Other lenders offer even more flavors. How do you choose?
To choose wisely, you need to understand the notion of amortization. Your monthly payment consists of both interest and loan principal. While the amount of the payment does not change from month to month, the allocation between interest and principal does. In the first month, you pay a large amount of interest, and a little principal. In the second month, the amount of interest is reduced, because you owe a little less principal; this leaves a bit more of the payment to apply to principal in the second month than in the first. This change continues at an accelerating rate through the term of the loan, till the last few payments are almost entirely principal.
With a fixed interest rate loan, the monthly payment never changes over its term. But with an adjustable rate loan, the payment will change whenever the interest rate does; the overall term, usually 30 years, never changes. The initial payment amount is calculated to amortize the loan over 30 years at the initial interest rate. At the first rate change–say, in three years–the payment is recalculated, to amortize the remaining balance at the new interest rate over 27 years.
Decisions, Decisions!
Three general patterns occur in mortgage interest rates. First, on fixed rate loans, shorter amortization periods carry lower interest rates; however, the payment on the 15-year loan will usually be higher. Second, adjustable rate loans carry lower rates than 30-year fixed rate loans. Third, the shorter the interval between rate changes on adjustable rate loans, the lower the interest rate.
Whether you should take an adjustable rate mortgage depends on many factors. The psychological one comes first: If you will be unable to sleep worrying about what the new rate will be in a few years, get a fixed rate loan. Next, how long are you planning to stay in this home? If the answer is three or four years, then a five-year adjustable loan might as well be a fixed rate loan.
You should also evaluate the spread in the interest rates. Assume the worst, and figure the interest rate will go up the maximum (typically two percentage points) at each change date. How long will it be before you would have paid less in total under a fixed rate loan? For example, my bank is currently quoting a 6.75 percent rate for 30-year fixed loans, and a 5.125 percent rate for a "three-and-three" adjustable, that is, one where the initial rate change occurs after three years and each three years thereafter. In this example, your cumulative payments would be higher on the adjustable rate loan after 81 months. There is no certainty the rate will go up that much, but you need to be confident you can handle a higher payment in three years, and again three years later.
That brings us back to the psychological factor: your tolerance for risk. An actor or free-lance director has considerably less predictable income than, say, tenured faculty in a university theatre department. The less stable your income, the less you can afford risk in your investments and home mortgage.
And then there is the question of your crystal ball. If you expect interest rates to go up substantially and quickly, that argues for a fixed-rate mortgage; if you expect stagnation, an adjustable.
I Can Always Refinance Again
Since most loans are calculated on a 30 amortization, each refinancing extends the final payoff date further into the future. Most people think of owning their home free and clear as an indirect form of retirement income, since an avoided expense is functionally the same as income. In the alternative, they consider selling the expensive house in Chicago, buying something less costly in a retirement community, and investing (or spending) the difference. The contrary school of thought is that paying off the loan is, effectively, investing the money at the interest rate of your mortgage, and that you can do better elsewhere. This assumes that you have the discipline to do the alternative investing–many people do not.
And if you know a solid, low-risk investment that pays more than the current 6.75 percent rate of a 30 fixed mortgage, would you please call me?
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 773/525-1778 (888/525-1778 outside the Chicago area).
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.