Pay off adjustable-rate mortgage or refi?


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Dear Dr. Don,
We have a seven-year adjustable-rate mortgage on a home purchased in January 2012 for $470,000 with no down payment. The interest rate until February 2019 is 3.625 percent. Over the past two years, we haven’t made much progress paying down the principal, now at $452,000. We have saved approximately $80,000. Would it be better to use this money to begin paying down the principal hoping to pay it off completely by 2019? At minimum, we’d hope to pay off a substantial amount and refinance the remainder. Yet another idea would be to use the savings for a down payment and closing costs to refinance into a 15-year fixed-rate mortgage.

— Anne Amortization

Dear Anne,
I generally think paying off the mortgage before retirement is a sound financial goal. But, homeowners must balance making additional principal payments on the mortgage versus investing for other life goals, like retirement and college savings.

My rule of thumb is that if you can expect to earn more on your investments than you pay on your mortgage (both after taxes), you shouldn’t rush to pay off your mortgage while still working. This is also true if you’re not contributing up to the limit of employer-matching contributions on a 401(k) plan.

I plugged your numbers into Bankrate’s mortgage payment calculator. Your loan balance is exactly where you’d expect after two years with no additional principal payments.

Homeowners typically choose a 7/1 adjustable-rate mortgage when planning to remain in the house only for the fixed-rate portion of the mortgage. It sounds like you plan to be in the home only for a short time. Switching to a fixed-rate loan can eliminate some of the uncertainty of interest rate risk.

Paying off $452,000 over the next five years is ambitious, even if using $80,000 in savings. If that’s an attainable goal, there’s no need to refinance to protect against higher rates. The savings aren’t going to be substantial enough to justify paying the closing costs. You would need to triple your monthly mortgage payment to pay off the loan in five years, including the $80,000 lump-sum additional principal payment.

Using the $80,000 to get into a 15-year fixed-rate mortgage increases your monthly mortgage payment by about $490 to nearly $2,665 a month. Lock into a rate and you can decide later whether to make additional principal payments while saving on interest expense. You also shorten the life of your loan.

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