Question: My wife and I bought a new home in a seniors community last November for $228,000, using a large down payment and taking out a $135,000 mortgage for 30 years at 7.75 percent. Now that mortgage rates have fallen, should we consider taking out a second mortgage to free that home equity for other uses?
Answer: Every time I write about mortgages, I get passionate responses from readers whose views run the gamut: Some say get the biggest mortgage you can, others say get the smallest.
Neither group is completely right or wrong; the answer depends partly on how you want to place your financial bets, and partly on nonfinancial issues such as whether you're happier without having a large long-term debt.
For starters, I'd resist the impulse to obsess about small differences in interest rates and instead look at actual dollars. You also might drop the idea of taking out an additional mortgage and instead consider refinancing replacing the original mortgage with a bigger one. After all, a lot of the refinancing fees such as title insurance and appraisal will be the same, or nearly so, no matter how large the mortgage. So why leave the 7.75 percent loan in place if, for the same closing costs, you can replace it with a loan at a lower rate?
At 7.75 percent, your $135,000 mortgage costs $967 a month. You should be able to find a loan charging 7 percent with zero points or 6.38 percent with three points. (Each point is an upfront interest charge equal to 1 percent of the loan amount.)
Assuming you expect to stay in the home for many years, the 6.38 percent loan probably makes the most sense, since the lower monthly payment eventually would outweigh the cost of points.
At 6.38 percent, a $135,000 loan would cost $844 a month a $124 savings. You'd break even on your three points ($4,050) in 33 months. After that, the $124 monthly savings would be gravy.
Keep in mind that if you itemize deductions on your tax return, cutting your payments by $124 would reduce your mortgage-interest deduction. If you are in the 28 percent tax bracket, you'd lose about $35 in tax deduction, cutting your total savings from the refinancing to $89 and extending the break-even time on your points to 45 months.
If you'll stay in the house longer than that, paying points makes sense. You also should consider how long that monthly savings would take to pay off the other closing costs.
Now, what about that second mortgage for the $93,000 you originally put down on the house?
It probably doesn't make sense to finance all of that. Your lender may require that you have 10 percent equity in the house, or $22,800, assuming it's still worth $228,000.
Moreover, as long as you have 20 percent equity, or $45,600, you are free of the onerous requirement to pay private mortgage insurance, or PMI. This could cost you $75 or even $100 a month.
So let's assume you keep 20 percent in the home, or $45,600, and replace the original mortgage with a new one for $182,400.
At 6.38 percent, the monthly payment would be $1,139, compared to $844 if you just refinanced your existing mortgage.
Of course, after paying off the old $135,000 mortgage, you'd have $47,400 in cash. Unless you really need this money for some important expense, the key question is whether it is better invested in the house or elsewhere.
Kept in the house, this money would "earn" 6.38 percent, since it would save you from having to make mortgage interest payments at that rate. That's not a terrific return but it's guaranteed, and it beats the 5.6 percent you'd get on a 30-year Treasury bond.
You might earn more with stocks or stock mutual funds, but only at the risk of losing money as well. Obviously, taking out a bigger mortgage with a bigger monthly payment raises your living cost and could leave you in a tighter spot if your income fell.
Since you're over 55, it might make sense to play it safe and you already have a safe investment in your mortgage. Of course, if you have a lot of other safe, fixed-income investments such as bonds, you could take your down payment money and gamble on stocks.
As I said at the start, only you can judge the nonfinancial issues: Would you be comfortable shifting your home equity to a risker investment? Would it bother you to take on a bigger monthly payment?
Still, there's no sense keeping the old 7.75 percent mortgage when you can get a new one at 6.38 percent assuming, of course, that you'll keep the new mortgage long enough for the monthly savings to outweigh the refinancing costs.