Homeowners taking out 10-year mortgages

Wall Street Journal ^ | June 2, 2003 | RUTH SIMON

[Dog Gone]

With mortgage rates setting new lows last week, a growing number of homeowners are doing something that was largely unheard of just a year ago: taking out 10-year mortgages.

It's part of a broader push by many borrowers to pay off their mortgages quickly by taking advantage of the lowest interest rates in more than 40 years. Some are baby boomers who want to get rid of their debt before they retire. Others are simply trying to save on interest costs by shortening their mortgages.

The interest savings on a 10-year mortgage are enormous. If someone borrowed $250,000 at 4.5 percent, the going rate at a major lender, the interest over the life of the loan would be only $60,915. By contrast, in the case of a homeowner borrowing that same amount for 30 years at 5.375 percent (longer-term loans typically carry higher rates), the interest would total $253,974.

The drawback, of course, is that your payments are higher in the short term. On that same hypothetical $250,000, the monthly payments would be $2,591 with a 10-year loan, compared with $1,400 for the 30-year loan.

At Countrywide Home Loans, a unit of Countrywide Financial Corp., 10-year mortgages now account for roughly 15 percent of mortgage loans. The volume of 10-year loans "was insignificant a year ago," says Doug Perry, first vice president of Countrywide Home Loans.

To spur demand, Countrywide has been sending direct-mail solicitations explaining the benefits of shorter loans to borrowers who are prepaying their existing longer-term mortgages.

Borrowers have been gravitating to 15-year mortgages from 30-year loans for some time. But the new 10-year loans are providing a fresh inducement even for people who have refinanced relatively recently.

Rich Schroeder, an account manager for a transportation company, took out a 15-year mortgage with a 6.5 percent rate last year. Now, he is switching into a 10-year, $116,000 mortgage with a 4.875 percent rate.

"I'm looking to get out from underneath the mortgage as quickly as possible," says Schroeder, who lives outside Detroit. The new loan will allow Schroeder to pay off his loan nearly four years earlier, while adding only $100 to his monthly payment. Schroeder says he considered refinancing four or five months ago, "but it wasn't worth making a move."

Earlier this year, the mortgage industry braced itself for a sharp decline in refinancing activity as the economy seemed poised to recover, which would drive rates up. Instead, the economy has remained soft, and fears of deflation have pushed rates to their lowest levels in decades.

The result is that refinancing activity is surging. The Mortgage Bankers Association recently boosted its estimate of 2003 mortgage volume to $3 trillion, up from last year's record $2.5 trillion.

Interest in the shorter loans is helping spur the latest round of refinancing. In April, U.S. Bank Home Mortgage introduced a 10-year fixed-rate mortgage that carries a lower rate than its 15-year mortgage; previously, the two mortgages carried the same rate.

"Our phone literally has been ringing off the hook," says Dan Arrigoni, president of U.S. Bank Home Mortgage, a unit of U.S. Bancorp.

Shorter-term mortgages of all types are gaining ground. At GMAC Home Finance, a unit of General Motors Corp., 15-year mortgages accounted for nearly half of recent refinance loans. Last year, about 20 percent of GMAC customers who refinanced opted for a 15-year mortgage. Chase Home Finance, a unit of J.P. Morgan Chase, says 15-year mortgages now account for about 20 percent of the loans in its pipeline, up from 15 percent six months ago. More borrowers also are refinancing their 30-year mortgages into 20-year and 25-year loans, lenders say.

On Tuesday, rates on 30-year fixed-rate mortgages averaged 5.51 percent, while 15-year fixed-rate loans averaged 4.95 percent, according to HSH Associates, financial publishers in Butler, N.J.

Mortgage rates could drop even further if the economy shows further signs of weakness. Mortgage rates typically track rates on Treasury bonds.

Of course, many homeowners aren't interested in shorter mortgages. Instead, they are using the low rates to lower their monthly payments. Or, they are taking cash out when they get a new mortgage.

Indeed, short-term mortgages aren't for everybody. Borrowers are committing to a higher payment for the life of the loan. If a homeowner's income drops, she will still have to make that steeper payment.

You can achieve some of the same benefits of shorter-term mortgage simply by taking out a 30-year mortgage and making extra principal payments. Pinched for cash? Make the minimum payment. One hitch: You typically won't get as low a rate on a 30-year mortgage as on a shorter-term loan. And many find it hard to stick with this self-imposed mortgage prepayment strategy.

In addition, people taking out a 10-year mortgage will quickly whittle away one of their biggest tax breaks: the deduction for mortgage interest. Principal payments aren't tax deductible. In the first year, the interest deduction for a 10-year mortgage at 4.5 percent is only about a fifth smaller than a 30-year mortgage at 5.375 percent. But by the fifth year, a borrower in the 27 percent bracket would see the deduction cut almost in half, calculates PricewaterhouseCoopers.

Borrowers don't always get a break for taking a shorter-term mortgage. Twenty-five-year loans are typically priced at the same rate as 30-year mortgages. Likewise, Bank of America Corp. offers the same rate on 10-year and 15-year loans. As a result, the bank says its customers are more likely to take out a 15-year mortgage and pay it off early if they are inclined.

Still, for many borrowers, a shorter-term loan has clear benefits. It allows homeowners who are several years into their current mortgage to take advantage of low rates without stretching out payments for another 15 or 30 years.

Don Genereux, an elementary school principal in Minneapolis, is replacing his $88,000 fixed-rate mortgage, a $25,000 home equity loan and some high-cost debt with a new $115,000, 10-year fixed-rate mortgage with a 4.375 percent rate. The new loan will boost Genereux's monthly mortgage payment by about $15 but cut his total borrowing costs by about $500 a month. Genereux, 55 years old, says he was already five years into his 15-year mortgage and didn't want to extend his loan further. "We're looking at retirement and change of career," he says. "We need to have a light at the end of the tunnel."

[speekinout]

You have to think about more than just the cost of the house. There are far too many seniors today who are "house poor". Most of their money is in equity in their homes, and reverse mortgages (the only way to get it out without moving) are far more expensive than the mortgage you can get while you're still working.
And if you intend to retire to a lower cost home or lower cost area, why would you ever want to pay off your current home? All you need is enough money for the next one.

I wish someone would tell me a good reason to pay off a house. I don't know one.
It seems to me that getting a mortgage with comfortable payments, and investing whatever you can in other things makes the most sense. If one part of the economy collapses (and housing can do it too) then you have some back-up.

[the bottle let me down]

I wonder what Rick's problem is? If a person pays only the required monthly payment on a 30 year mortgage, at the end of that 30 years, he will have paid at least double the selling price.

Primarily, it's a liquidity thing: yes, equity is an asset, but it can't be tapped quickly, and in some cases, it can't be tapped at all.

For example, you make extra payments and pay off your mortgage, so you own your house free and clear. Now you lose your job--try tapping into your equity to support yourself until you find a new job. You won't be able to. If you'd been investing the money in other, more liquid places rather than in paying off your mortgage early, you'd have a huge fund to live off of.

[Skywalk]

Yep and your house, one hopes, will at least maintain its value if not increase dramatically. This increase in value happens whether you have paid the mortgage or not. So why spend the extra money when you derive no further increase in the value of the house?

[Dog Gone]

If the real estate market goes down, you could get caught with negative equity.

Sure, but that could happen with my 30 year note, too. I'd only be refinancing my balance, so I'm not clear what difference that would make.

[E. Pluribus Unum]

Instead of refinancing my 30 year/6.125% loan with 29.5 years left on it, I am paying an extra $800 a month which will pay it off in 9 years.

If I refinanced at 4.5% and made the same monthly payment it would be paid off in 8 years, but I have to come up with $2500 closing costs right now and it would only save me about $4000 in interest.

If you already have a fairly decent rate and have the discipline to pay extra each month, refinancing is not really necessary to obtain huge savings in interest, plus if something happens and your income is drastically cut you have the safety net of being able to drop the extra monthly payment and not lose the house.

[Petronski]

Meanwhile down the street, other people are taking out seven year car loans...on cars from GM!!!!

[Skywalk]

Peep the link to Edelman's new rules of money, you'll be converted.

Of course, if the gubmint gets rid of the mortgage interest deduction altogether, it takes a bit of the wind out of the sails but it still stands on its own.

Oh, and NO STARTER HOMES! Stupid idea.

[Dog Gone]

I wish someone would tell me a good reason to pay off a house. I don't know one.

Well, I guess you could reach an arrangement with a mortgage company to keep paying them forever, but the concept of not sending them a monthly check seems appealing to me.

[E. Pluribus Unum]

I wish someone would tell me a good reason to pay off a house. I don't know one.

Because once it is paid off you can get by on a lot less monthly income. That means you could take a job that didn't pay as much, but that you really liked.

[Skywalk]

That is about the only thing appealing about it.

[Petronski]

Anyone considering doing this should keep in mind that if their current rate is good, and there's no prepayment penalty in the note, the borrower is free to send in the 10-year payment amount and get all these benefits without closing costs and without locking in to the higher payment.

[sysvr4]

Rick is right, folks. The thing you guys are forgetting is that interest paid on mortgages is tax deductible. This means that your effective interest rate is considerably lower than the stated rate once you consider the tax benefits.

For example, assume the following:

1) Loan amount of $150,000
2) Interest rate of 6%
3) Term of 30 years
4) 30% tax bracket for borrowing individual

Over the term of that 30 years, you'd pay $173,757 worth of interest. But at the same time, you'd save $52,127 over that same 30 years in taxes from the interest deductions. Thus, you'd have an effective cumulative interest of $121,630 ($173,757 - $52,127).

That being the case, your effective interest rate is closer to 4.5% than the stated rate of 6%. It may be even lower... the higher your tax bracket, the more your tax savings and the lower your effective rate. The prevailing thought is that you can invest your money over that 30 years at a higher rate than your (this example) AFTER TAX interest rate of 4.5%, meaning you'd be to the plus with any money you DON'T invest in your mortgage, but DO invest in an effective portfolio/401k/IRA/whatever.

So, the point is, borrow for as LONG as you can, as cheaply as you can, because you're borrowing cheaper than you can make money (you do believe your portfolio can do better than 4.5% over the long term, yes?) and invest whatever you have left in tax-deferred vehicles and you'll actually come out way ahead of where you would if you put the money in your house.

I know this will never convince a number of you, but this is standard practice amoung people "in the know" financially. You don't have to believe it, but you should ask someone you trust that knows what they're talking about before passing judgement. Hope this helps,

Jeff

[luckodeirish]

Do it! I just refinanced a rental townhouse in Irvine, Calif. 3 years ago no one wanted to re-fi it cause it was a rental prop. This time, I had 4 lenders wanting to do business with me. Did a 10 year, and the mortgage is now only $46 month more, take in to consideration that it was $1,284.04 per month, so the $46 is really not a lot. Happy as a clam about it, too.

[E. Pluribus Unum]

If the real estate market goes down, you could get caught with negative equity.

Which is worse?

1) Having the market value of a house that you own free-and-clear go down?

2) Having a house that is worth less than the outstanding balance of the loan?

[Fred Mertz]

I need to go for a 10 year vs a 15 year loan. I have 20 years left on my 30 year mortgage and I don't know what I'm waiting for.

Thanks for posting this article.

[Skywalk]

This is from that link:

That translates to a mortgage. Why carry 18% credit card debts - which are not tax-deductible - when you could instead carry an 6% mortgage that is tax-deductible? Ditto for auto loans, school loans and personal loans. Your mortgage is the cheapest money you'll ever buy, so it makes sense to use it as much as you can. The next time you buy a car, finance it with a home mortgage instead of a car loan.

There I go again, talking about carrying debt. That's what scares you. You know that if you owe $5,000 to credit cards and then lose your job, VISA can't reclaim that sweater you bought. But if you have a home equity line of credit which you fail to repay because you're out of work, the bank can take your house. That's why you don't want to borrow against your house - in case you're out of work and money gets tight; it sure would be a relief knowing that you don't have a big mortgage payment to make.

That's wrong again, I'm afraid. First, it's unlikely that you're going to find yourself in such dire straights. But then, that's what financial planning is all about, so let me do some effective planning for you. Let's look at Pat and Ed. They both earn $50,000 a year. Both have $20,000 in savings. Both buy a $120,000 house.

Pat wants to minimize his mortgage, so he uses his $20,000 in savings as a down payment, and he opts for a 15-year loan at 5.5%. His monthly payment is $817, but only 55% of that payment is tax-deductible interest; the rest is principal. Therefore, Pat's net after-tax cost for his mortgage is $669. And to pay off his mortgage even quicker, Pat sends in an extra $100 with every payment. Of course, these payments are devoted entirely to principal, and therefore provide no tax deduction.

Ed listens to me, and therefore obtains a 30-year mortgage at 6%, putting down just 5% and financing the rest. Even though his mortgage balance is bigger than Pat's ($114,000 compared to $100,000), his monthly payment is just $683. That's not all: A full 83% of the payment is interest, meaning that Ed's after-tax cost is just $496 a month - $173 less than what Pat has to pay! Ed invests this savings of $173 each month for five years, earning 8% after taxes per year. And instead of sending an extra $100 a month to his mortgage company, as Pat does, Ed adds it to his savings. Result: Over five years, Ed accumulates nearly $19,000. Because he kept $14,000 from his original $20,000, he's able to keep that money invested, too. Now, that money has grown to $21,000. All told, Ed has accumulated $40,000 in savings and investments.

Suddenly, both men find themselves out of work. Because Pat used all of his money as a down payment, he has no savings to tide him over. True, he's got $48,000 worth of equity in his house, but he can't access it. He tried, but the bank turned him down for the loan. "But I've got all this equity in my house!" Pat exclaimed. It didn't matter, the loan officer said, because banks only lend money to people who can repay the loans. With no job, Pat has no income and therefore he cannot qualify for a loan.

Indeed, Pat has fallen victim to the biggest misconception in real estate: That a mortgage is a loan against the house. It isn't. A mortgage is a loan against your income. Without an income, you cannot obtain a loan. If Pat doesn't fix his income problem in a hurry, he'll lose his house. How ironic: Pat, who never wanted a mortgage in the first place, is now in financial jeopardy because he was trying to get rid of one too quickly, and now can't get another!

Ed, though, is in much better shape. With $40,000 in savings, he's easily able to make his payments each month. In fact, even if he doesn't find work for a long time, his home is not in jeopardy. At the rate of $586 a month, Ed won't run out of money for nearly eight years!

[Fred Mertz]

Rick is right, folks. The thing you guys are forgetting is that interest paid on mortgages is tax deductible.

Screw the IRS and their complicated formulae. Screw the financial institutions while you're at it.

"Get out of debt" is the best advice I gave to one of my Army friends before he retired with a fat paycheck as a Colonel.

[Joe Hadenuf]

I agree. It's best to have the low monthly payment of a 30 year and just prepay it if you have the extra dough. At least then, if you hit a rough spot, you're not stuck with a killer high monthly payment.

Excellent point.

[Skywalk]

If you have substantial loot that you can invest ON TOP of paying extra to get rid of the mortgage quickly, then perhaps.

But financial planners would disagree.

Even if the IRS is gone and the deduction goes the way of the dodo there are STILL advantages to the 30 year note. A perfunctory knowledge of economics assists in understanding the situation. Does it guarantee success? No, but hey this is life not Paradise.

I look at it like this: It's better to have bigger cash stocks or liquid assets than to simply not have debt. But house notes are COMPLETELY different type of debt than credit cards.

But even with credit cards, sometimes it's better to carry a low balance and make the minimum so that you have a greater cash supply on hand for a given "tough" month.

[Dog Gone]

It seems to me that Rick's argument is based on a presumption that you can substantially gain more by investing your money elsewhere than in reducing the debt. That is often true, but it really hasn't been true in the last couple of years. If you had invested that money in the stock market, you might well have negative returns.

And, unless you're investing in some tax-sheltered investment, you have to consider what your after-tax return really is. Look at my calculations in post 22. I don't think I can guarantee a 20% return on my money for the next 10 years anywhere else. Where am I wrong?