When a 15-year mortgage makes sense
Dear Liz: You recently advised a couple who were in sound financial shape about possibly refinancing their home loan to a lower interest rate. You suggested a 15-year loan to make sure they entered retirement without a mortgage. Why not recommend getting a 30-year loan to get the lowest required monthly payment, then making extra payments to get the loan paid off faster? This approach offers the flexibility of being able to drop back to the lower payment in the event of a job loss or other financial setback. They sounded like well-disciplined people and probably could turn that 30-year loan into a 15-year loan by paying 13 payments a year instead of 12.
Answer: Refinancing to a 30-year loan can certainly make sense for people who want to lock in the lowest payment and maintain their financial flexibility in the face of possible financial setbacks. You’re also right that this couple seems disciplined enough to make the extra payments to get the loan retired before they do.
However, you missed a key factor: This well-disciplined couple had a mortgage with an interest rate of 5.875%. That indicates they’ve had this mortgage for a while. If they’ve paid down enough of the principal balance, they may be able to refinance to a 15-year loan with a significantly lower interest rate (as in slightly over 3%) without dramatically raising their payments. Many people, when faced with that option, would want to lock in the lower rate.
No down payment saved? You’re not ready to buy a home
Dear Liz: My wife and I are considering buying a home for the first time. We’re planning to switch our accounts from our bank to a credit union. We’re in the midst of receiving a bad report from the bank, and that’s why we want to change. But is that a wise choice when we want to buy a home? Also, what options do we have for a mortgage when we don’t have any money for a down payment? Are we locked into an FHA loan, or are there other choices? We are middle-class people making an average of $40,000 a year with no kids and OK credit scores.
Answer: If you don’t have a down payment saved, you aren’t ready to be homeowners.
Homeownership is expensive, with lots of unexpected costs constantly popping up. Some are relatively minor, like having to replace a worn-out appliance, while others are major, such as having to replace a furnace or a roof.
That’s why homeownership isn’t a good idea for people who aren’t already in the habit of living below their means and saving a decent proportion of their incomes.
Take the next year or so to tweak your spending and save up a down payment. You’ll need at least a 3.5% down payment to qualify for an FHA loan. A bigger down payment will give you more loan options and won’t leave you upside down on your home from the first day. A 20% down payment is often best, since you can avoid private mortgage insurance.
A year also will give you time to polish those credit scores from “OK” to “good.” The higher your scores, the better the interest rate you’ll receive.
But the fact that you’re receiving a “bad report” from your bank is worrisome. You don’t specify what happened, but anything that could be reported to the credit bureaus, such as a missed credit card payment, could cause major damage to your scores. Simply switching to another institution won’t prevent that. And if you’ve piled up a bunch of bounced checks, your credit reports may not be damaged but you could find it difficult to open new accounts at other financial institutions.
Whatever happened, you should try to straighten it out with the bank before you decamp, even if you ultimately decide to switch accounts.
Why refinancing isn’t as simple as it could be
Dear Liz: Why does a request to lower the interest on an existing mortgage require a new appraisal, inspection, title search, etc., when the home is the same? Think how much money could be put back into the economy with a simple keystroke.
Answer: The short and obvious answer is that “nothing is the same.”
Home prices are down 33% from their 2006 peak, with even bigger drops in many areas. Lending standards are dramatically tighter as well. When your loan was originally made, lenders might not have cared much if your home’s size or amenities were fudged, or if the wrong “comparable properties” were used to arrive at your home’s value, or if you made the income or had the assets you claimed. Now they care, deeply, about all of those things.
Even if the world hasn’t changed, your property may have. Deferred maintenance could have reduced its value, while improvements may have increased it. Lawsuits or other problems may have popped up that affect the title.
And when you think about it for a moment, you’ll realize that all those loans that were made so easily in the past — with simply a few keystrokes — are what helped lead to the economic mess we’re in today. Yes, the pendulum may have swung too far and made refinancing unnecessarily tough, but the old easy lending standards were simply unsustainable.
Why you shouldn’t pay down your mortgage
Dear Liz: We have a 7% fixed-rate mortgage with a $150,000 balance and a second, adjustable rate mortgage with a balance of $100,000. I’m self-employed and my wife doesn’t work. My income fluctuates a lot every month. We just sold a property and have $240,000 left after taxes. Should I pay off both mortgages or just the adjustable loan?
Answer: When deciding whether to pay off a mortgage, many people focus on how much interest they could save or what their “return” on their money would be. (If you’re in a 35% tax bracket for federal and state income taxes, for example, your return on paying off a 7% mortgage would be 4.6%.)
In reality, though, most people have better things to do with their cash than pay off relatively low-rate, tax-deductible debt.
Are you, for example, on track with your retirement savings? Do you have a substantial emergency fund? Most families would be wise to set aside a cash reserve to cover three to six months’ worth of expenses. Someone who is self-employed with a non-working wife might want to boost that emergency fund to 12 months’ worth of expenses.
Are you adequately insured? Since your wife is financially dependent on you, you probably should have a substantial life insurance policy. You may want to get one on her as well, if she cares for minor children and you’d have to hire a nanny if she died. You may also need disability coverage.
If you’ve covered all these bases and still want to pay off your mortgages, feel free. Otherwise, put the money to better use.
Don’t tap retirement funds for a bigger down payment
Dear Liz: My husband is 30 and I’m 28. We were told the importance of contributing to our retirements and so now have $58,000 saved. We have an additional $65,000 saved for a down payment. Due to my son’s recent liver transplant, I won’t be able to work for an indefinite amount of time, so we are reduced to one income of about $60,000. We have to move to get into a better school district and can’t decide what to do. We’re currently looking at homes in the $200,000-to-$250,000 range. My husband wants to use my $38,000 retirement savings (which would be $30,000 once taxed) to get into a home with a lower payment that will not require me to work. I’m scared to do this since everyone preaches retirement, but at this rate we won’t have a mortgage when we retire. Plus, who wants to be a millionaire at 60! I want to enjoy life while we’re young and our kids are young. We are very disciplined but just don’t know what to do. Thanks!
Answer: You can enjoy life and still refrain from doing stupid things that will jeopardize your retirement.
And tapping retirement funds early is typically pretty stupid. You’re giving up all the future tax-deferred returns that money could have earned. By the time you’re 60, that $38,000 could have grown to nearly $450,000.
You also may be underestimating the tax bite. You can withdraw up to $10,000 from an individual retirement account for a first-time home purchase, but the remainder of the withdrawal will be penalized at a 10% federal rate, plus whatever penalty your state assesses. The entire withdrawal will be taxed at your current income tax rates.
The taxes and penalties are substantial for a reason: You’re supposed to leave this money alone. Since you probably won’t be able to contribute to a retirement account for a while, it’s even more important not to squander these funds.
Besides, the extra $30,000 would lower your monthly payment by about $160 on a 30-year fixed-rate mortgage at 5%. That doesn’t seem like much of a payoff considering what you’d be giving up.
