Refinancing is a hot topic these days, with quite a few people considering it. And why wouldn’t they? Mortgage interest rates are at RECORD lows, so homeowners like myself want to take this opportunity to save on interest or cut years off their loan. It’s a good idea right? Maybe.
I’m working on a refinance (refi) and in true money nerd form, I’m running the numbers and my options. Option 1 is restarting my term which will lower my monthly payment. Option 2 is paying a tad bit more each month to shave years off my term.
Both have their benefits, but there is an additional financial consideration I want to bring to the forefront: opportunity cost.
Let’s get into what I mean so you can gain a better idea of which direction you should head in for your refinance.
First, let’s go over my original terms and options
- 20-year loan at 3.875% that I took out in 2018
- Another 20-year loan at 2.75%, which would lower my monthly payment by $180
- 15-year loan at 2.375%, which would raise my payment by $10.
Now, when refinancing a home, inherently we want the best terms we can afford, while minimizing interest and paying the loan off as quick as possible.
After all, who wants to pay MORE than they need to for the same thing? Especially since interest eats up the majority of house payments for a decent period of time.
That said, I do think it’s worth fully understanding your opportunity costs of quickly paying off your home, and whether or not you should care.
Before I get into that, I want to make sure we’re on the same page on what I mean by opportunity cost.
What is Opportunity Cost?
An opportunity cost is the lost potential gain of an alternate decision you didn’t make. By making one decision, that means you aren’t choosing any of the alternatives. If that alternative was worth more than the decision you made, you incurred an opportunity cost. If this doesn’t make sense now, it soon will.
Home buying rules to remember
Ok, so when examining the opportunity cost of buying or refinancing a house, there’s a few things to keep in mind.
The first thing to remember is the money you put into a home is money you could have put elsewhere. That “elsewhere” for the sake of this conversation is an investment with the objective of earning you money, e.g., the stock market.
The second thing to remember is that your primary residence does not *earn* money. Well, unless you are doing some form of “house hacking” and renting it out in some capacity.
The third thing to remember is that it’s ok for none of this to matter a lot to you. I’ll explain what I mean by that in a bit.
Buying a home is kind of a money pit
Most people’s interest in buying a home is financially rooted in the assumption the home value will go up, and that whenever you go to sell it, you’ll have a gain. But financially, that’s also based the assumption you’ll stay in the house long enough for the proceeds to be more than what you spent in totality.
What did you spend? Well you bought the house of course, then you got annual tax payments, insurance, utilities, furnishings, maintenance, landscaping, maybe HOA fees and other random expenses. Ya know, all sorts of money going out.
That starts drifting into the convo of whether a primary residence should be viewed as a true “asset”, or a “liability”. But, I will share my thoughts on that another time; back to my point.
My point is, your house does not regularly put money in your pocket. However, money is regularly coming out of your pocket.
Why does this matter? Well, because that’s money you could be investing into an asset that does put money in your pocket.
What else could you do with your money?
There’re all sorts of investments out there: rental properties, franchises, and even vending machines. But my favorite, and easiest to enter is the stock market, so that will be our example.
Now for the sake of simplicity in this conversation, when I mention the stock market, I am talking about the Standard & Poor’s 500 index. Or, S&P 500.
The S&P 500 is an index of the 500 largest U.S. publicly traded companies across multiple sectors. Because it’s so diverse, it’s a good and broad measure of the overall stock market.
Since its existence, the S&P has returned a strong 8% on average. Meaning, if you were to invest in an index fund that tracks the S&P 500, you can pretty much expect an 8% annual return over a 20-30 period of time. Which is also similar to a 20-30-year mortgage loan term most people sign up for.
Now, here’s where it’s gets interesting
Would you rather pay my original loan rate of 3.875% or earn an 8% return in the stock market? I would hope you rather earn money than pay it. Earning this annual market return mathematically beats paying just about any mortgage interest rate.
Using that simple example, you could make the argument that throwing every free dollar you have at your mortgage is not the best use of your money. After all, we JUST looked at how you could earn 8% on every dollar you throw at the market.
You also could make the argument that getting the lowest mortgage payment possible is better than paying a higher payment in order to get a lower interest rate and term. If your payment is lower, that’s more available cash you could invest and earn a BETTER return on your money.
Liquidity has its advantages. I can thank Ron Caruthers’ tweets for reminding me of that.
So how much money are you missing out on?
If you recall my refi options, I could choose a 15-year loan at 2.37% and pay $10 more each month. Or, I could restart my 20-year loan at 2.75% and see my payments drop $180.
The latter puts more money in my pocket today, it would just take me longer to pay off the house.
But what could I do with an extra $180/month in my pocket? Well, I could always apply that to the principal of the loan.
Or, I could put it in a S&P 500 Index Fund that averages an 8% return. Let’s look at the difference over 15 years between saving interest by going with the more aggressive home repayment plan, compared to investing the $180/month difference.
As you can see, after 15 years I would save $28,000 in interest by focusing on paying off the house. If I invest the $180 difference, I would have almost $59,000. More than a $30,000 difference.
But, my house would be paid off quicker if I go with the 15-year loan, right!?
Sure, If I chose the 15-year mortgage and purely focus on paying off the $159,000 loan, it would be paid off in 15 years. If I go with the 20-year and invest the $180/month lowered payment, after 15 years I would have $59,000, but I would still owe about $48,000 on my mortgage.
But here’s the beautiful part. Even if I go with the 20-year, I could simply take that $59,000 investment balance after 15 years and PAY OFF my $48,000 loan balance. Even after doing that, I would still have money left over.
Mathematically, it just makes more sense to refinance to another 20-year loan term and invest the difference in payments that I’m saving each month.
The key is having options
So far, I have looked at purely investing the $180/month. But that’s not the only thing I could do with the money.
I could just as easily put that money into any other type of investment. Could be a traditional investment like a rental property, or even investing that money each month into advertising MY business.
Or, I don’t have to invest the money at all. Maybe I have an expensive necessary purchase I know I will need to make soon, e.g., home/car repair or medical expense, and could save towards that.
If you have outstanding high interest debt (credit card debt), maybe THAT’s a great place to put that additional cash.
The point is, this approach gives you options. And when evaluating options, you have to make sure the potential value/return, is worth going down that path.
Does it always make sense to stretch out a loan term?
I can think of a bunch of situations where it can make more sense to stay as liquid as possible.
That said, in order for this to work, it assumes a few things:
- You actually put the money to a productive use. It does me no good to run all of this math to see what I could do with an extra $180/month if I just blow the money. For this approach to work, you have to be disciplined enough to stick to the more productive plan
- You trust the math and like having options: Hey, personal finance is personal. While it makes mathematical sense to invest the difference, you may just prefer to pay off the debt by directly putting all money towards the loan. That’s your choice. Just remember, in the above example I could invest the difference for 15 years and STILL use that money to pay off my house if I wanted to. This is about having options.
- Your risk tolerance doesn’t mind the investment risk. The nice thing about paying off your house is that it’s a guaranteed return on investment. With each additional dollar towards the principal, you KNOW you are saving your agreed interest rate. What’s not a guarantee? Investing rates of return. Sure, historical returns over the last 100 years say I should get 8% on average, but that’s not a “guarantee” it’s a “likelihood”. You may prefer the “guarantee” of saving 2.75% of interest over the “likelihood” of earning 8%. I have a higher tolerance for risk, so I don’t mind taking the chance on investing. If you go the investing route, ensure that approach aligns with your tolerance for risk.
But, what if this isn’t right for you?
Just to play Devil’s Advocate here, there are some situations where you should just aggressively pay off the home and bypass the investing route.
- You prefer the debt-free peace of mind. Hey, there’s nothing wrong with wanting to be debt-free ASAP. It can certainly provide peace of mind, and paying off your mortgage is still way better than blowing the money.
- You desire a guaranteed rate of return. As mentioned earlier, saving on interest is a guaranteed return. I can’t be mad at you for wanting that.
- Your financial self-control is a work in progress. Let’s keep it real: for some people, having more money in their pocket wouldn’t work out well. If this speaks to you and the money would burn a hole in your pocket, it might be better if you just put it towards the mortgage.
Final Thoughts: It’s Your Choice
At the end of the day, you have to do what makes sense for your pockets, your current situation, and your peace of mind. For me, I am stretching my loan about a bit more so I can seek a higher return on my investment with the extra cash in my pocket. Whichever direction you go in, make sure you weigh your options, run the numbers, and always consider opportunity cost.