How to ditch mortgages before retirement

Don TaylorQuestionDear Dr. Don,
I am 55 years old and am considering taking advantage of current low interest rates to refinance my existing mortgage debt. The maturity dates of these loans roughly coincide with my planned retirement date from full-time employment. I like that concept, and do not wish to extend the debt merely to improve short-term cash flow.

I am considering refinancing the two current fixed-rate loans into a single product, and my financial adviser has suggested the HELOC route, which involves minimum origination fees. My intent would be to keep the term of the loan about the same, but either reduce the monthly payments a bit, or, pay the same amount, and be finished a few months earlier. I'm also curious about how the refinance changes my need to escrow property taxes and homeowners insurance.

I have reservations about the seven-year future of interest rates. The mortgage debt is divided, as described below:

The primary mortgage balance is $103,000 at 5.375 fixed with a maturity of January 2018.

The home equity loan balance is $36,900 at 6.74 fixed with a maturity of August 2017.

I'd conservatively estimate the home's appraised value at $325,000.
-- Not Anxious in New Jersey

AnswerDear Not Anxious,
I can understand the attraction of restructuring your mortgage debt, and refinancing with a HELOC, or home equity line of credit. Short-term rates are expected to stay low in the near term, and it's the near term when you'll be paying the most interest expense, especially since you want to pay off the loan in the next seven to eight years. Combine that with the lower closing costs of a HELOC and it seems like the winning solution.

My issue with the HELOC is that it only takes two Federal Reserve moves of 0.25 percent to get the 5 percent HELOC interest rate over the existing rate on your first mortgage.

You could just refinance the home equity loan and you'd have a little more wiggle room for Fed moves over the planned loan term, but you'd lose the opportunity to refinance your first mortgage at a lower rate. Since you're planning to pay off the mortgage in the next seven to eight years, I like the idea of using a 7/1 ARM as a cash-out first mortgage. Bankrate doesn't report national averages on a 7/1 ARM, but it appears to be close to the Bankrate national average for a 5/1 ARM at 3.99 percent. The tables below show the different scenarios, although it doesn't allow for rising interest rates on the HELOC.

Mortgage and refi scenarios
ExistingExisting first mortgageExisting home equity loanCombined
Loan balance:$103,000.00$36,900.00$139,900.00
Interest rate:5.375%6.74%5.735%
Loan term (months):8479varies
Total interest:$20,816.92$8,891.87$29,708.79
RefinancingRefi with a HELOCRefi with a cash-out first mortgageRefi only home equity loan with a HELOC
Loan balance:$139,900.00$139,900.00$36,900.00
Interest rate:5%3.99%5.00%
Loan term (months):848484
Total interest:$26,196.05$20,676.26$6,909.46
Estimated closing costs:$100.00$4,110.00$100.00
Pretax savings:$3,412.74$4,922.53$1,882.40
Estimated after-tax savings at 25%:$2,559.56$3,691.90$1,411.80

I used the Bankrate 2010 Closing Costs Study to find the average closing costs for New Jersey. The after-tax savings estimate assumes that you can fully utilize the mortgage interest deduction on your taxes and it isn't just replacing the standard deduction. The cash-out first mortgage also doesn't consider the lost investment income on the $4,110 in estimated closing costs.

The HELOC savings shown in the table represent the best possible solution for those refinancings. But remember, a couple of Fed moves, and your savings are diminished. The 7/1 ARM requires a bigger upfront investment, but locks in the mortgage rate over your planned loan horizon.

I don't see the escrow account as an issue, one way or another. If the lender requires an escrow account, it's the price of admission to the refinancing. If you're not required to escrow taxes and insurance, then you can budget for it by setting up an automatic deposit from checking into savings.

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