Mortgage amortization questions

November 3, 2017 5:58 AM

I'm trying to figure out whether I should "recast" or refinance my mortgage. I've never been able to understand how amortization works. Also, is it smart or dumb to prepay a mortgage in this low rate environment?

My lender (PenFed) will let me "recast" my my adjustable rate mortgage. I'm almost five years into a 30-year ARM, which adjusts every five years (PenFed's 5/5). Under the "recast," PF would give me a better rate than the one I would get under the normal reset (roughly 3.25 versus 4.5), the remaining amortization period would remain the same (25 years), and I think they would re-amortize the loan to reflect extra principal payments I have made over the last few years.

All of that sounds good, except the part about keeping the 25-year remaining term. If I refi'ed into a new 30 year loan (the same 5/5 product), my monthly payments would be lower by virtue of the longer term. I might get a slightly better rate too. There would be some closing costs.

Here's my main question: if I plan to pay the same monthly amount under all scenarios, which includes extra principal under all scenarios, am I better off with a new 30 year term because I will be paying more "extra" principal in a scenario in which my monthly minimum is lower? I think the answer is no, but I have to admit I don't really understand why. Maybe it's because in the 30-year scenario there is less of the minimum payment allocated to principal?

Bonus subsidiary question: rates are still so low, it feels like a "dumb" investment to prepay. Over the last 10-20 years, if you could borrow money at 3% and stick it in the stock market, you'd have done very well (even putting aside the mortgage interest deduction, which I guess is sticking around in some form). Also, I feel like putting our money into our house is sort of "dead money" because we are unlikely to move or otherwise tap the equity for a decade or more. But I feel like there is some kind of virtue or ethic in trying to get the mortgage down. Is my thought that I "should" try to pay the mortgage off earlier irrational? I know this depends on different factors of each person's own financial picture, but I'm curious how others think about this.

posted by Mid to Work & Money (11 answers total)

If you plan to pay the same monthly amount under all scenarios, and you don't foresee any scenario under which it would be difficult to meet the minimum payment for the 25-year recast, the interest is the really the only thing that matters. If you're going to pay off the mortgage in 20 years, it 100% does not matter whether it's amortized for 25 or 30 years (you would also want to consider the fees associated with a recast vs. a refinance).

There are a lot of "extra mortgage payment" calculators around on the internet that you can use to demonstrate this to yourself.

As for whether or not it makes sense to prepay the mortgage, I mean, financially it's almost definitely not your best bet but there are a lot of worse things you could do with the money. It's OK to go with your gut sometimes.
posted by mskyle at 6:18 AM on November 3, 2017 [1 favorite]

Bret Whissel's amortization calculator shows a schedule and will solve for any variable, so you can pop in an increased payment and see exactly what effect it has.
posted by wierdo at 6:37 AM on November 3, 2017 [3 favorites]

If you're planning to pay the same amount each month no matter what, then the recast (with lower rates) is better than refinancing unless the refi has significantly better rates, because the refi has closing costs and, as I understand your question, the recast does not?

If you foresee a future where your income drops precipitously, then the refi does give you a better buffer against that, because it'll have a lower minimum payment. That's the only real advantage I see unless, as mentioned previously, the refi rate is significantly better than the recast rate.

As for aggressively paying down the principal, well, opinions differ. I did it but then I had a mortgage back in '08, when rates were several points higher. There's an extent to which it's psychological rather than purely financial: debt feels oppressive and reducing debt feels good. That (as well as the fact that investment in your mortgage is much lower-risk than most comparable investments) may be a good enough reason to do it. There are good compelling counterarguments out there, but it's not as if aggressively paying down your mortgage is a particularly bad idea.
posted by jackbishop at 6:38 AM on November 3, 2017

I recast my mortgage. It was free to do, I believe. My minimum monthly payment was lowered, the mortgage length is the same, and I continue to pay extra into principal each month with the goal of paying off early.

For your bonus question, assuming you max out retirement/HSA etc first...Beyond that, I use YNAB to budget. Anything extra earned each month then gets split evenly into non-retirement vehicles and mortgage principal--that way I'm hedging my bets on your question, which I used to mull over a lot.

Feel free to MeMail me if you want to discuss further.
posted by rabidsegue at 7:05 AM on November 3, 2017

There are a few issues you need to answer and it looks likely that the calculations are needed to get to the right answer. Let's start broad:

(1) "dumb" investment to prepay?

The two issues here are about returns and opportunity cost/risk.

There are fewer and fewer low risk vehicles for savings that have an interest rate above those you mention, but generally you can outperform your mortgage rate provided you aren't investing within a time frame that would make you susceptible to something like 2008. Eg, a smallcap index fund will probably perform better if you're investing in a period roughly the length of your mortgage.

The other issue is risk, especially liquidity. Even though you'll pay taxes and fees for an untimely withdrawal of investments, if you pay your mortgage principle the money is really just gone from your books. So if you run into problems, you don't have those funds to solve a problem (you could use a HEL or something, maybe).

(2) Is recast better than refi?

See jackbishop

(3) Is recast/refi better than doing nothing?

This is where the math gets a little tricky. Since you can take monthly extra payments and apply them directly to the principle, if you are over-paying monthly then you're probably doing it by a large enough amount so this last point doesn't matter, but...

If you recast/refi it will push out the period (years) of your mortgage. The most salient fact you should understand about mortgage amortization is that the debt is frontloaded compared to the principle. What?

This means that if you extend the period out further, you should realize that your monthly payments will now be paying a higher % towards interest compared with principle. This combined with any strategy to overpay may make the 'stay put' a better return compared with refi/recast...again, depending on the rates and other terms.
posted by Reasonably Everything Happens at 7:49 AM on November 3, 2017 [2 favorites]

You haven't mentioned the option of refinancing to a fixed-rate loan. I certainly wouldn't recommend stretching out the window of uncertainty that is the ARM for an additional 5 years through a refi in a scenario where mortgage rates are still low but rising and expected to continue to rise unless you do expect to move within the next 5 years, in which case logical choice is to recast at the lower rate. For most people it is indeed "illogical" to paid down the mortgage early, but none of us are perfectly rational economic actors. If you have the discipline to put any surplus income toward retirement instead, that's generally the most logical choice. But if it's more likely to get eaten away by lifestyle inflation, then certainly it makes more sense *financially* to put it toward the mortgage than to put it toward, say, a bigger/newer car or fancier vacations.
posted by drlith at 7:54 AM on November 3, 2017

If you recast/refi it will push out the period (years) of your mortgage.

Those are two different concepts. Recasting should not push out the mortgage. It lowers the required monthly payment based on how far ahead you are and frees up more cash flow. The P/I ratio doesn't change because the payoff curve is still exponential and you're still at the same payoff point of the curve.
posted by Talez at 8:00 AM on November 3, 2017 [1 favorite]

One question that is often overlooked when making these evaluations is whether or not the debt is recourse or nonrecourse.

For example, in California, purchase money loans for real property are nonrecourse. That means that, if you default on the loan, the lender can go after the property, but not YOU. (May only apply to primary residences as well.)

If you refinance a loan, you remove the purchase money characterization, making the entire loan recourse.

The advantage to this (as the general public discovered in 2008-2009) is that if the property value plummets, and you are either unable or unwilling to keep up with the payments, then you can simply walk away from the purchase money debt. But if that has been paid off, then that debt will follow you until it is paid (or discharged in bankruptcy).

I don't know where you are located, so the law may be different where you live. If the answer to this question may change the answer to the other questions you have asked, I recommend talking to someone in your state to determine how this works in your state.

IAAL, IANYL, TINLA.
posted by China Grover at 8:28 AM on November 3, 2017 [1 favorite]

They are probably pushing the recast because they don't want you to refi into a fixed-rate mortgage. This would be a very good time--perhaps the last very good time in a while--to do so. I would look at that, as well.

But if you don't, if you are intending to make the same overpayment til the end of the term, it doesn't make a difference whether you recast or not. It'll be paid off at the same time. The difference would come if you should run into a situation where you couldn't continue to overpay. Then, you'd have a little more room to decrease your payment without falling behind (though ultimately you'd end up paying more over the life of the loan). If they're not charging you anything for the recast, it's harmless to give yourself that option.

I agree with most people here--while in theory you can do better in the market than in a mortgage, overpaying isn't a dumb thing to do...at least if you already have an adequate emergency fund and are making other adequate retirement savings. The problem with home equity is that it's not liquid. Even taking out a HELOC means you're effectively paying for access to it. But there's no "should" about it. Just math informed by your own preferences and risk tolerances.
posted by praemunire at 9:33 AM on November 3, 2017

(BTW, it is true that at least in most nonrecourse states a refi will make a nonrecourse loan into a recourse loan. However, that distinction only really matters if home prices drop so much that you are actually underwater on the mortgage and then have to sell. If you are five years in and have been consistently overpaying, the odds of that happening are relatively low, because you have already repaid a significant chunk of the debt and thus don't need to recover that amount through the sale of the property to be able to repay the loan in full. Not impossible, though.)
posted by praemunire at 9:39 AM on November 3, 2017 [1 favorite]

You show a lot of insight into the psychological factors behind this decision. What financial mistakes do you tend to make? Because, sure, from an investment standpoint paying off the mortgage probably doesn't make sense in the current record-low interest rate climate. That equity will just sit there, not earning anything. At the same time, it certainly feels good to pay off that huge debt. As a compromise what we did was refinance into a loan that will be paid off roughly when our original 30-year loan would have been paid off had we not refinanced. (As an aside, if they are straight up offering you a recast, you are way overpaying on your current loan, as noted above. They wouldn't make that offer unless they felt it was more likely than not that you'd leave.) Refinancing is a pain but saving a quarter of a percent is major money over time.
posted by wnissen at 5:30 PM on November 3, 2017