NEW YORK (Money magazine) -
Chances are these days, your home is your most profitable investment. Sky-high appreciation rates have added hundreds of thousands of dollars to many homeowners' personal wealth.
As such, many are looking for ways to unlock the equity in their homes, from mortgage refinancings to reverse mortgages. Others, too, are wondering whether it pays to prepay their loan.
We've got you covered:
1.) How do I know when it's worthwhile to refinance?
Balance your potential savings on monthly payments with your refinancing costs. A couple who borrowed $175,000 six years ago at 6.63 percent today owe about $162,000 on the loan. Refinancing that balance with a 5.75 percent loan will save them about $175 a month, according to the online calculator at Bankrate.com. Assuming they pay typical closing costs of between $3,000 and $5,000, it'll take 17 to 28 months for the savings to make it into their pockets.
Ah, if only it were really that simple. Would-be refinancers also must consider how far they are into their current mortgage. If that couple refinances with another 30-year mortgage, they'll be paying for their home for 36 years. What's more, because of the way mortgages work, refinancing could add substantially to the amount of interest they pay. In the beginning of a mortgage, most of the monthly payment goes to the bank as interest, with a very tiny amount applied to the principal balance. Over the years, that balance shifts, so that by the end of the 30 years, nearly all the payment goes to principal. When you refinance, you start over paying mostly interest.
Let's return to the couple with the six-year-old mortgage. Over the life of that loan, they'll pay $228,604 in interest. Refinancing to a 5.75 percent mortgage will cut total interest paid to $178,339. Sounds good, but wait: The couple already has paid more than $68,000 in interest in the first six years of their existing loan, cutting their total remaining interest to $160,586. Refinancing, then, will cost them $17,753 in interest on top of the initial closing costs. So in reality it will take this couple nearly 10 years to start saving money on the refinancing.
Our couple can still make refinancing work if they plow some of their monthly payment savings back into the new mortgage. Paying an extra $95 a month shortens the refinanced mortgage back to the original payoff date, and chops the total interest paid to $136,363, because the extra money goes straight to the principal. Of course, this move reduces the amount the couple saves on monthly payments to just $80, which increases the amount of time they'll need to recoup their closing costs to at least 37 months. But if these folks plan on staying in the home, this still represents a good deal.
Family needs add wrinkles, too. Miami financial planner Linda Lubitz advises clients who are nearing retirement and plan on downsizing to refinance their existing balances to five-year or seven-year adjustable-rate mortgages, which bear interest rates about a percentage point less than standard 30-year loans. Although they'll be paying lots of upfront interest again, the real goal is to lower the monthly payment as much as possible and bank the savings. "And if they're planning to sell in five years," Lubitz adds, "then they'll pay off their mortgage and not have to worry about the adjustable part."
If big expenses like college tuition are around the corner, you could try pulling extra dough out of your home in what's called a cash-out refinancing. Here, you refinance for more than you actually owe on your loan and pocket the difference. This can work better than a home equity loan, because mortgage rates are lower than home-equity rates. Warning: If your new loan amount would top 80 percent of your home's value, this option isn't all that good an idea, because you'd be forced to pay costly private mortgage insurance.
2.) How can I convert the equity in my home into income during retirement?
The most obvious way is to sell your home and buy a smaller, less-costly abode, investing the difference in bonds and dividend-paying stocks. Downsizing works even more effectively if you move to a town with smaller property tax bills or a region with a lower cost of living.
If you're determined to stay in your home, and your other income sources fall short of your budget, consider a reverse mortgage, which lets you borrow against your home and not pay back the debt as long as you live there. Interest piles up over the life of the loan (because you're not making payments), and the total amount must be paid when you die, sell your home or move away. Bronwyn Belling, head of AARP's Reverse Mortgage Project, says retirees are increasingly using reverse mortgages to pay off small first-mortgage balances to eliminate their monthly payments.
This may sound like easy money, but be careful. These loans are more costly than traditional mortgages because there are monthly servicing fees as well as required insurance to protect the lender against a drop in your home's value. In addition, unless your home appreciates at a good clip, repaying a reverse mortgage may leave little or no equity for your heirs.
The first step to deciding whether a reverse mortgage is for you is to bone up on the subject. Check out CNN/Money's in-depth look at the pros and cons of such tools. An excellent AARP guide is also available at www.aarp.org/revmort/ or by calling 800-424-3410 and requesting publication No. D15601.
Here are the basics. Borrowers must be over 62. The amount you can borrow depends on your age, the value of your home and the interest rate. You can take the money as a lump sum, regular monthly loan advances or (most commonly) a credit line that's used only when you need it. Best bet: The federally insured Home Equity Conversion Mortgage, available through 150 lenders, which tends to have lower closing costs than other types. Go with a lender with expertise in this complicated product, such as Financial Freedom, a unit of Lehman Brothers (888-738-3773), and Wells Fargo Mortgage (800-336-7359). Before signing, says Belling, "do your homework and explore all the alternatives."
3.) Should I use my extra cash to prepay my mortgage?
All things being equal, paying your mortgage off early would be wise to do--few things in life are more satisfying than finally owning your house free and clear. But all things are not equal under the tax code, and consequently, paying off your mortgage now could limit your financial options down the road.
Say you've paid off your mortgage early but suddenly need some of that equity to pay for a boat or a grandchild's tuition. You could get a new mortgage, but the law says the interest on that new mortage is not tax deductible since the original mortgage on the house was already paid off. "It's something people should think about it before they pay off a house," says Ernst & Young accountant Evan Snapper.
If you have revolving-credit debt, definitely pay that off first. The average credit card charges 13 percent interest these days, while prevailing mortgage rates range from 4.25 percent to 6.25 percent.
Even investing the money might make more sense. If you have a 5.75 percent mortgage and are in the 30 percent tax bracket, the "real" rate you're paying is only 4 percent after you factor in the value of the mortgage interest deduction. Any number of investments--from investment-grade bonds to high-dividend stocks--would be good bets to produce better than 4 percent after-tax returns. And in the 15 percent tax bracket, your real (or after-deduction) rate is 4.9 percent. If you think you can do better than that (particularly in an IRA or other tax-deffered account), you're better off investing the money, not pre-paying the debt.