This article will deal with three basic questions regarding home mortgages:
- Is a shorter-term mortgage better than a longer-term mortgage?
- What is the significance of “points” on a mortgage loan?
- How can you determine if mortgage refinancing is likely to be worthwhile for you?
The information that follows should help answer these questions.
Many home buyers are being led to believe that a 15-year mortgage is clearly preferable to a longer-term mortgage, because of all the interest they will save by paying off their mortgage sooner. They are being told that if they choose the shorter-term mortgage, they will be able to save tens of thousands of dollars over the life of the mortgage.
However, the benefits of a shorter-term mortgage are not that certain, as indicated by the following excerpts from The Wall Street Journal (11-6-85):
The total interest payments on the shorter loan are indeed dramatically less. But many people taking those shorter loans . . . won’t end up with anywhere near that much extra money in their pockets. Although most of them will probably do better with the shorter loans, the actual savings are likely to be more modest than they think.
One reason is that the . . . higher monthly payment on the shorter loans is money that could otherwise be invested.
Borrowers will generally do better with a longer-term loan if they can invest at an after-tax rate that exceeds the after-tax rate on the mortgage.
The potential cost savings is . . . only one factor to consider in weighing a 15-year mortgage.
Probably the biggest single question for borrowers is whether they can afford the higher monthly payments.
Instead of a 15-year mortgage, you may want to consider a longer-term mortgage, which will have a somewhat higher interest rate, but will give you flexibility as to when, or if, you make higher monthly payments.
Another important question is whether the home buyer who chooses a longer-term mortgage will have the self-discipline to consistently invest the difference in the amount of the monthly payments. If not, then the shorter-term mortgage would be a way to ensure that the money would be invested (in the house) rather than spent.
Mortgage companies use “points” as a means of receiving additional income without having to charge as high an interest rate as they would otherwise. By offering the lower interest rates on their mortgages, the mortgage companies appear to be more competitive. Furthermore, since the “points” are paid in cash at the time of closing on the mortgage loan, the mortgage companies receive this income sooner than they would if they charged a higher interest rate instead.
An article in The Wall Street Journal (3-25-87) provides the following insights regarding how to assess the significance of “points”:
[H]ome buyers sometimes aren’t . . . sensitive about points, at least partly because many don’t fully understand how points affect their overall costs.
One rule of thumb is to equate each point with about one quarter percent on the interest rate. . . . So an 8 3/4% loan with two points is equivalent to roughly a 9% rate with one point – at least during the first few years.
How long the borrower plans to stay in a particular house is a major factor. . . .
[T]he less time the buyer plans to keep a house, the more points add to the effective annual rate.
Therefore, buyers who expect to be in a house for more than a few years — generally, more than five years — will usually benefit from paying more “points” to get a lower rate on their mortgage. Conversely, buyers who expect to buyers be in a house for a shorter period of time will generally find it cheaper to pay fewer “points,” even if they have to pay a somewhat higher interest rate on their mortgage.
Note that the effect on income taxes should also be taken into consideration. “Points” paid on a mortgage to purchase a home are fully tax deductible for the year in which they are paid. However, “points” on a refinanced mortgage must be prorated over the life of the loan.
If the homeowner is required to pay “points” and closing costs to refinance a loan, refinancing may not be worthwhile unless the interest rate on a new mortgage is at least two percentage points lower than the interest rate on the existing mortgage.
On the other hand, if no “points” are required and the lender pays all of the closing costs, just half a percentage point difference in the interest rates may be sufficient to make refinancing attractive.
In such cases, the new payment can be subtracted from the old payment to determine the amount of the savings, if any.