Mortgage Refinancing That Nearly Cost Me $370,000
, on September 18, 2007
I mentioned previously that I made many financial mistakes in the past. One of the more serious ones was refinancing my mortgage from 30 years to 15 years in 2003 (about 4 years after I purchased my home). On the surface, I did a brilliant job of saving nearly $97,000 in interest expenses and ending my mortgage 11 years sooner.
Here is the catch, if I invested the $4,000 refinancing expenses and the $288 monthly payments into an S&P 500 Index Fund. I might have $467,505 after 26 years (assuming a 10% CAGR). So, I am really looking at a $370,588 loss.
In addition, there are other factors that hurt me:
- Inflation — Assuming a 2% inflation rate, a dollar on year 30 will be worth about 56 cents in 1998. Thus, inflation helps people with long-term mortgage. With a shorter mortgage, I gave up some of that advantage. For instance, a dollar on year 30 will be worth about 70 cents in 1998.
- Tax deduction for mortgage interest — Lower interest expenses means less tax deduction. I gave up about 25% of $97,000 (or $24,000 in tax savings).
Fortunately, there are factors that help (or can help) me also:
- Catch up investment — When I paid off my mortgage, I can invest $1,427 into an S&P 500 Index Fund and I might have $350,000 in 11 years.
- Capital Gains Tax and Fund Distributions — I do not have to worry about capital gains tax and yearly taxes for interest, dividend, and distributions. Capital gains can amount to about $70,000 (15% of $467,505).
- Discipline to invest — To get $467,505, I have to invest $288 every month without touching that money. That is a big assumption.
- Interest payment savings and owning the house sooner is guaranteed!
After all these factors, I think I am all right (extremely lucky to be, since I did not consider everything discussed here). However, this example does demonstrate a few important points:
- Making prepayment or refinancing may not be a good choice.
- Interest payment saving is not the only factor.
- Cash flow, things we can do with the extra money, tax implications, and inflation are important factors.
In general, I can conclude two rules of thumb:
- Refinancing only make sense if the interest rate on the original loan is significantly higher AND you plan to live in the same house long enough to offset refinancing expenses.
- Making prepayment only make sense if your interest rate is approaching 8.5% (S&P 30-year historical performance is 12.41%, therefore, I use a conservative investment performance of 10% minus 15% capital gains tax, or 8.5% net)
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About the AuthorPinyo
is the owner of Moolanomy Personal Finance
and an entrepreneur with over 20 years of business experience. He has a strong appreciation for business management, investing, and wealth building. He has written for many online publications, including American Express and U.S. News.
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