Mortgages Revisited
A look at the things you can do to change your loan once you're already making payments.
The Squareholder Value team had a corporate retreat this weekend in Maine, so this week’s post is on the shorter side. Don’t worry, there’s just as much hard-hitting content as always. (I got rid of the filler that usually takes over my posts. Other than this parenthetical.) This week I return to the topic of mortgages. Specifically, what do you do when you already have a mortgage but want to change the terms? You will want to have the mortgage workbook attached to this earlier post as you read.
My research for this post revealed that there are lots of products and services that can change something about the monthly payment cadence for your mortgage: payment amount, interest rate, timing of payments, number of payments, etc. I’m going to focus on proactive changes in this post, as opposed to things you might do in distress. I’m also going to assume that you started with a “standard” mortgage instead of something like an adjustable-rate mortgage (ARM). Finally, I won’t consider second mortgages/HELOCs1. With those caveats, I think there are essentially three things you can do to change the terms on your mortgage: accelerate payments, refinance, or recast. You can probably find other means for saving money besides these three, but any other offer is probably one of these in disguise if you squint at it.
I will look at the three options in detail below. To explain them, let’s use a baseline mortgage with the following parameters:
Loan amount = $250,000 (e.g., for a $300,000 house with a $50,000 down payment)
Interest rate = 7%
Loan term = 30 years (i.e., 360 monthly payments)
Monthly payment = $1,663.26 (computed from Excel)
Option 1: Accelerate payments
Also called prepaying, this is the simplest way to change your stream of mortgage payments. In this scenario, you simply pay more than the minimum monthly payment. You can do this as frequently or infrequently as you want. For example, maybe you come into a large sum of money and want to use it to reduce your principal. Alternatively, maybe you got a raise and can now afford to increase the amount you spend each month. Either way, the mechanics of accelerated payments are the same. At the beginning of each month, you are charged interest on the outstanding amount of the loan. Anything you pay above that is applied to principal, meaning that it reduces the amount you owe. This is true whether you make your minimum payment—which consists of interest and principal—or more than that. The only special thing about your prescribed payment is that it exactly reduces the outstanding balance to zero after 360 payments (or whatever the term is).
It’s reasonable to think that if you consistently overpay on your mortgage, then you should be able to pay less some months. That is not how it works; your monthly payment is fixed, and you are obliged to pay at least that amount each month. This means that if you accelerate your payments, the only thing that can give is the number of payments that you make. If you overpay, then eventually you will start removing payments off the end of your mortgage. Let’s look at our baseline example. Suppose that you make your standard monthly payments for five years. At that point, your outstanding principal balance is $235,328.97. (Check out column F in the spreadsheet attached to the mortgage table post.) Starting in the sixth year—i.e., payment 61—you increase the amount you pay each month to $2,000. That $336.74 increase to your payment all gets applied to reducing principal. This will be compounded in the next period, because you’ll be charged $1.96 (=$336.74 * .07/12) less in interest, meaning that $1.96 more of your payment will be applied to reduce principal.
In your mortgage spreadsheet, enacting this change is easy. Just overwrite the formula for payment in month 61. If you want to keep up that $2,000 payment for the rest of the loan term, copy it down to the bottom. What you need to do next is look at the outstanding balance column. Since you’re paying more than what is needed to zero out the balance after 30 years, you’ll now see a row where the ending balance switches from positive to negative. Per the picture below, after the 259th payment, the balance is $719.36. The following month, you would then pay off your mortgage with a final payment of $719.36 + $4.20 = $723.56 to account for interest in the last period. With these parameters, increasing your monthly payment from $1,663.26 to $2,000 after five years shaved 100 months (~8.3 years) off your mortgage.
How should you decide whether this is smart to do? The cold, emotionless finance answer would probably be to create a stream of “cash flows” representing the situation (cf., my post on mortgage points). From months 61 to 259, there is a cash outflow of $336.74 to account for the extra payment you’re making. In month 260, there is a cash inflow of $939.70 (=$1,663.26 - $723.56) to account for the reduced payment in that month. In months 260 - 360, there is a cash inflow of $1,663.26 to account for the fact that you’re saving your entire payment. Excel’s IRR function says that the IRR of this stream of cash flows is 0.58% monthly, or 7.23% annualized. (Note that the “present day” in that calculation is month 61, when you would be making the decision.)
In reality, there’s more at play. You may decide that you want to reduce your debt while you can, even if you’re not thrilled with the internalized rate of return of increasing your payment. Alternatively, you may worry about losing your job, in which case reducing your savings by accelerating payments has its own risk. As I’ve said many times before, I’m not a financial adviser, so I have no opinion. One final thing to watch out for is that some mortgages come with penalties for prepaying. I don’t think that would ever be a problem for this example (with small, consistent increases to the payment), but please read the fine print in your mortgage before signing.
Option 2: Refinance
The second way to change your mortgage is to refinance it.2 Mortgage refinancing is basically trading in your current mortgage for a new one. The way it works is that the bank gives you a new loan, which is immediately used to pay off the existing mortgage. Given that description, you can really change any of the parameters. However, there are a few common use cases. The first is a cash-out refinance, which is where you get a new loan for an amount that’s larger than what you owe (popular with the get-rich-quick TikTok crowd). The result would be a lot of cash going into your pocket, which you can use however you want. The next is a cash-in refinance, which is where you make a large down payment on the second mortgage, thereby decreasing the amount you owe. You would do this presumably to reduce your monthly payment or the number of payments (or both).
The third use case is a rate and term refinance, which is where you take out a new loan to change either the number of payments or interest rate on your loan. For example, if mortgage rates were high when you purchased, you may want to refinance when rates go down. Since 1980, rates for 30-year mortgages have fluctuated between 2.5% and over 18%, so this is definitely a nice option to have. Depending on market conditions and your goals, refinancing can lower or raise your monthly payment (or neither). The catch with a refinance is that you are getting a new mortgage, which means that you’ll have new closing costs. These are typically thousands of dollars. That being said, refinancing definitely could be worthwhile.
As expected, a good framework for assessing the refinance decision is to find the return on your “investment” of the closing costs. For example, suppose that you have made your minimum monthly payment for 15 years on the baseline mortgage. At that point, your outstanding loan balance would be $185,047.17. If 15-year mortgage rates at that time are around 4%, then you could refinance to a 15-year mortgage with a monthly payment of $1,368.77. This gives you a stream of cash inflows of $294.48—the difference in payments—for 180 months. If the refinance cost is 5% of the loan amount, that would be $9,252.36 upfront. Saving ~$2,920 per year for 15 years gives about a 25% return on that investment. Going from 7% to 4% is a pretty big drop, so refinancing appears to be a good move in this case (if you can front the closing costs). The downside of a refinance is that it is the most expensive option I’ve discussed because of the closing costs. Also, since this amounts to a new loan, it may negatively impact your credit score, at least temporarily. Finally, there are some restrictions about when you can refinance. For example, you may have to wait a year after getting your initial mortgage.
Option 3: Recast
Prepaying reduces the number of mortgage payments that you make. Refinancing (usually) reduces your interest rate. The third option—recasting—reduces your monthly payment. A recast starts off like prepaying: you make a payment that exceeds your minimum payment. The difference is that instead of continuing thereafter with your normal monthly payment, the bank recalculates your payment based on the new principal amount. The interest rate and term on your loan stay the same.
Let’s revisit the example from the prepayment section. After five years of making the minimum payment on your mortgage, you decide you want to pay more. This time, instead of increasing your payment to $2,000 each month, you recast with a one-time payment of $25,000. This reduces the principal on the loan from $235,328.97 (the ending balance after 60 payments) to $210,328.97. With a recast, you recompute the monthly payment with the same interest rate (7%) and the original term (25 years, or 300 payments, remaining). This gives a new payment of $1,486.56, which shaves $176.69 off of your original payment. I’ll spare you the same calculation for a third time, but it is straightforward to turn the initial investment and payment deltas into a stream of cash flows and compute the IRR.
The primary advantage of a recast is that it is cheaper than refinancing. There may be a nominal fee, but there are no closing costs. There is also no credit inquiry, since you are not getting a new loan. It contrast to accelerating payments, it has the advantage of reducing your monthly payment. This could be appealing if you have money on hand now, but you’re concerned about your cash flow in the future. (For example, maybe you are self-employed or work in a volatile industry.) The disadvantage of a recast is that it requires a bigger upfront investment. Most banks have a minimum amount that you need to pay in order to recast. (A quick Google suggests that Wells Fargo’s minimum might be $20,000.)
There you have it. Thanks for reading today’s post. If you learned something, please subscribe and share with your network.
As the name suggests, a second mortgage is when you take out a second mortgage, secured by your property, while the first one is still active. Typically, you can borrow some percentage of your equity in the home, which is given by the market value of the home less your outstanding loan balance. For example, if your outstanding balance on a home worth $500K is $200K, then you might be able to borrow ~80% of $300K. A HELOC (high equity line of credit) is a type of second mortgage wherein you can access your stake in the house as a line of credit (as opposed to getting a lump sum cash payment like you do for a regular mortgage).
Credit to Rocket Mortgage for this section: https://www.rocketmortgage.com/learn/how-does-refinancing-work