It has been a while since we did an MMM challenge, so I’ve got an extra good one for you today, one which can save many homeowners out there $105,000 over a 15-year period. The challenge is: Getting yourself a better rate on your mortgage.
Looking at the ING Direct* website recently, I noticed that home loans were going for an astonishingly low rate of 2.99%. The last time I paid attention to mortgages, it was to refinance my own house a couple years ago, and at the time even the 5% rate seemed amazing to me. The lesson to me was that in this weird financial aftermath of the Great Recession, there are some sweet deals to be had for those paying attention. Any reader who has not recently refinanced to a lower rate should definitely do some shopping around.
But today I noticed there is an even more advanced strategy that has opened up. Check out the current APR spread on interest rates, which you can look up on places like Bankrate, (and also check SoFi – typically better loans without an origination fee).
5/1 ARM loan: 2.972%
15-year fixed: 3.604%
30-year fixed: 4.410%
These rates include all fees as part of the APR number, so when comparing to your own interest rate, it should be equivalent to getting the rate above and paying no fees. Lender fees are silly and are often way too high from less reputable lenders. ING Direct seems to have some of the lowest loan fees overall. But again, the rates above supposedly are the effective rate over the life of the loan after including the fees.
Before I became mortgage-free this year, my strategy was always to go for the 5/1 ARM mortgage. That way you get the lowest rate for 5 years, and you can really go crazy paying off principal of the house because your interest cost is so low. If the rates start to creep up at the end of the period, you can always lock in for a longer period at that time.
Some people, out of fear of the unknown, like to go for a longer lock period. Thus in the United States, the 30-year loan is very popular. The issue with 30 year loans, however, is that they are stupid. They are deliberately designed so that you start off juuuust barely paying any principal at all, $263 per month on a $200,000 loan, so that you really just scrape along in debt for a good part of your lifetime. It is so close to the tipping point that if you cut the payment just $200, it would be a 100-year loan. A few dollars lower, and it would be an infinite-year (interest-only) loan. Going a few dollars higher, on the other hand, gets you out of debt drastically sooner.
Now, certain Advanced Mustachians will point out, “But I prefer an interest-only loan, because I can choose when to make principal payments on my own schedule. Of course I won’t really take 30 years to pay it off, but since the interest rate is low I want to stay leveraged to make bigger investments in stocks instead”.
OK, fine, for those people the 30-year is fine in some cases. But still not in today’s market. Because look how much lower the rate is on the 15 and 5 year mortgages!
Let’s say you have a mortgage right now: $200,000 at 4.5 % on a 30-year schedule. Your monthly payment is $1013/month, of which 750 is interest and 263 principal.
If you are too conservative to switch to a 5/1 loan, then I still recommend that you go out tomorrow and refinance your loan into a 15-year fixed loan instead. You don’t have to worry about interest rates going up after 15 years, because YOUR HOUSE WILL BE PAID OFF THEN!!
But can you afford the payments?
Surprisingly, because of the lower interest rate and the stupid almost-infinity nature of the 30 year mortgage, you can easily afford them! Check it out:
The monthly payment on a the same $200,000 mortgage with a 15-year schedule at the much lower 3.604% APR is only $1439! Only 426 bucks a month more, and all of a sudden your payments are doing this for you: $839 principal, $600 interest.
You’re paying $426 more per month, but your interest costs have actually dropped by $150 per month and your principal payment has more than tripled. Congratulations – you’re actually paying off your house, sukka!
Over the lives of the two loans, the 30-year holder will pay $165,000 in interest, but YOU will only pay $60,000 in interest.
I think almost everyone can find a way to scrape together $400 per month when such a wealth-building opportunity is at stake.. right? The frugality tips alone that have been shared by Mr. Money Mustache in the past month have already freed up more than that amount of money. Cut your cable TV, drop to a less expensive car, ride a bike for local errands, drink less beer, stop buying coffee outside the house. You’re already more than there.
If you still don’t agree, feel free to stop by my new retail location next to Mister Money on Main Street in Longmont for a complimentary PUNCH IN THE FACE!!! Because it might help instill some wisdom that is already quite obvious to me : $105,000 in additional wealth** over 15 years is worth working for!
**Some Fancy Math on the issue:
Using a simple mortgage calculator and fast forwarding to the end of year 15, the two examples above would have you in these positions:
30 year mortgage holder:
-paid $1013/month for 15 years
-has $182,000 in payments remaining to go.
15 year mortgage holder:
– paid $1013/month for 15 years PLUS an extra $426 per month
– $0 of extra payments to go
– this $426/month has saved them $182,000 of future payments.
Note: I had to change this footnote after an astute reader pointed out it was confusing. Because these payments are stretched out over a long time, the actual equivalent return you’re getting on your $426 payments takes a bit of work to figure out. In the comments, you’ll see that I came up with a figure of 6.78%. Still quite amazing for a guaranteed investment return, so Do it!!
We considered financing a 15 year loan and saving an extra % on the interest. Instead we chose to take a 30 year loan and pay extra on the principle, for the piece of mind knowing that if our financial situation changes, we could always go back to a $750 mortgage instead of a $1,100 we pay. We are on track to pay off the loan in 15 years instead of 30.
However, over the course of the 15 years, we will pay an extra $13.000 or $70 per month for the difference in interest rates. If I had it to do over again, I’d have gone with the 15 year loan and had the $70 extra cash flow to bank in case of emergency.