“I have a recently purchased home with a $180,000 mortgage for 15 years at 4.63 percent. My new investment advisor suggests refinancing into a new 30-year mortgage at 5.85 percent to 6 percent, and investing the difference in payment. He says this will allow us to retire sooner. I am 61 and was planning on retiring at 66. I understand his argument, but I hate to give up the ultra low 4.6 percent interest rate and the peace of mind of paying off the house sooner.”

Your investment advisor is either an idiot or a scoundrel. He is a scoundrel if the new loan he wants to put you into is one in which he has a financial interest.

On a $180,000 loan, the monthly payment at 5.85 percent for 30 years is about $327 less than at 4.63 percent for 15 years. Extending the term to 30 years reduces the payment by more than the higher rate increases it. Your investment advisor wants you to invest that $327, arguing that you will be better off down the road if you do.

You will be better off if the investment fund you accumulate over time becomes larger than the difference between the loan balance you will have at that time and the smaller balance you would have had if you kept the lower-rate and shorter-term mortgage. For example, if you accumulate $20,000 after five years and your loan balance is only $5,000 higher at that time than it would have been, you would be $15,000 ahead.

In fact, there is virtually no chance of your coming out ahead. Over your time horizon of five years, you would have to earn a return of more than 38 percent a year to make this happen. If you are in the 27 percent tax bracket, you would have to earn more than 24 percent after tax. If you hold to the strategy for 10 years, the required returns drop to 20 percent before-tax and 13 percent after-tax. These returns are still far higher than any available on investments your advisor can put you into.

I calculated these returns, as you can, from calculator 15a on my Web site. The calculations ignore any refinancing costs. These would make the proposed strategy look even worse.

I have yet to find a legitimate exception to the following rule: refinancing into a higher-rate loan reduces your wealth.

Broker shouldn’t decide for borrowers

“I am a mortgage broker. I’ve prepared many loans for clients by using the lender’s rebate to pay my fee and other closing costs. True, the rate the borrower pays is higher, but my customers are spared significant out-of-pocket expenses. What is your view of this strategy?

It is okay as long as the borrower knows what you are doing and chooses to compensate you and cover other closing costs in that way. But the decision should be the borrower’s, not yours.

Wholesale lenders offer numerous combinations of interest rate and points, including positive points and negative points or rebates. For example, on a 30-year fixed-rate mortgage, the lender might quote 5.5 percent at zero points, 5.25 percent at 1.5 points, and 5.875 percent at a rebate of 1.5 points. If the broker is looking to make 1.5 points on the deal, the borrower who elects to pay 5.5 percent must pay the broker 1.5 points in cash, but the borrower who pays 5.875 percent has the broker’s fee paid by the lender.

Although there are no statistics on this trend, my impression is that a large proportion of borrowers today pay interest rates high enough to command rebates from lenders that at least cover the broker’s fee. Unfortunately, many mortgage brokers make this decision for their clients, whether it is appropriate for them or not. In effect, they tell the borrower “The rate is 5.875 percent and, good news, you don’t have to pay my fee.” It is a much easier way to do business than wrangling with borrowers over fees.

My objection to this way of doing business is that the broker is depriving the borrower of the opportunity to make a high-yield investment. A borrower who pays 1.5 points to reduce the rate from 5.875 percent to 5.5 percent will earn 17.4 percent return on his investment if he holds the loan for 10 years. If he holds it for only five years, he earns 7.4 percent, which is still pretty good. (These number are taken from calculator 11c on my Web site.)

The borrower who doesn’t expect to have the mortgage for fvie years is better off avoiding upfront costs by accepting a higher rate. But again it should be the borrower’s decision, not the broker’s.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at MtgProfessor.com.


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