Q:The popularity of interest-only loans has always baffled me. My wife and I have a 30-year
fixed-rate mortgage at 6 percent in the amount of $345,000. The property is worth at least $600,000.
Our income is now higher, and we are thinking of refinancing our loan to a 15-year fixed rate so we can pay the loan off sooner and become debt-free.
We don’t have a lot of money in our savings or retirement accounts and we think that a 15-year loan will force us to pay off the loan. Is this a good idea?
A: You are certainly correct that a loan amortized over 15 years is akin to a forced savings plan. Your payment will be about $850 more each month, but you will save thousands in interest cost over the life of the loan. Whether a 15-year loan is a good idea depends upon your objectives.
Normally, I would probably recommend against taking out a 15-year loan to folks who do not have a lot of liquid savings in the bank. Your main asset is the equity in your home, which is an illiquid asset. In order to turn your equity into cash, you need to either sell the house or take out a bigger loan and take cash out.
While taking out a 15-year loan will result in significant interest savings, it also means you are paying an extra $850 per month to increase the equity of your home, which as I said, is an illiquid asset. Here are some questions that you need to ask yourself.
m Would you be better off keeping the 30-year loan and investing $850 per month into a liquid savings account?
It’s never a bad idea to have a little cash in the bank for emergencies. If, for example, you need to buy a couple of plane tickets to visit a sick relative, it’s certainly better to buy them with available cash than with a high-interest credit card.
• What about investing some of the $850 into a tax-deferred retirement account?
Maximizing the cash contribution to this kind of account can result in significant tax savings each year.
• Do you have any credit card debt?
It would certainly make sense to pay off high-interest consumer debt before paying down a low-interest, tax-deductible mortgage.
• Are you financially disciplined?
This question is perhaps the most important. While my arguments for keeping a 30-year mortgage may be valid, if you are unable to take an extra $850 and invest it wisely, then a 15-year loan will force you to build wealth faster.
I have had clients in your situation. One client had more than half a million dollars in home equity, no savings or investment accounts and less than $1,000 in his checking account. No matter how much I tried to convince this fellow that his financial picture was out of balance, he insisted on a 15-year amortized loan with a much higher payment.
He finally confessed to me that while he agreed in principal that he should build some liquidity rather than accelerate the pay down of his mortgage, he simply said that he is not disciplined enough to save money. He needed a 15-year loan because it would force him to pay down the loan. Fair enough.
Sit down with your wife and try to answer these questions. It will help you decide whether a 15-year loan is right for you.
Henry Savage is president of PMC Mortgage in Alexandria. Reach him by e-mail (henrysavage@pmcmortgage.com).
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