Investment options that someone would consider risk-free

Here’s a scenario that some readers may relate to.  Let’s say you have some extra money that you don’t want to invest in anything that isn’t risk-free; perhaps it was an $100,000 inheritance, proceeds from a property sale, or an extremely large commission on a sale.  You want to make sure it is there when you go to purchase your next house in about 5 years.  The options you are considering include an FDIC-insured savings account, FDIC-insured certificates of deposit, a money market fund, and treasuries.  Let’s say the absolute best rate you can find is a 3.25% five year CD, keeping in mind that you will have to pay taxes on the interest you earn.  Let’s also say you have a $900,000 mortgage on your current house and it has 25 years left on the mortgage term.  The reason you are going to purchase a house in about 5 years is that you expect to sell your current house at that time.  Your youngest child will be headed to college, and you plan on using the proceeds to downsize into a newer, less expensive house.  For the sake of this illustration, you are only considering truly risk-free options, not chasing a higher return by taking on risk.

Recasting your mortgage

There is another risk-free option that might appeal to some.  You can use the $100,000 to pay down your mortgage and then ask the lender to recast the mortgage with the same interest rate and same remaining term.  Doing this would reduce your monthly payment immediately, without changing the 25 year remaining term on the loan.  There is no investment risk; your contractual monthly payment is reduced regardless of the direction of the stock market, a recession, interest rate changes, etc.  If your original loan was a 30 year fixed rate mortgage of $989,000 at a 4.375% interest rate, you would have roughly $900,000 left in principal after 5 years.  Paying the loan down by $100,000 and recasting it with the same interest rate and term would decrease your payment from $4937.93 per month to $4389.17 per month (a savings of $548.76 per month or $6585.14 per year).  Over a 5 year period, that savings would total $32,925.70.  However, some of the savings comes from paying less in principal as well; it is not just a difference in interest.  The amount that would save in interest over 5 years is $20,598.17.  By comparison, had you left the $100,000 in a five year CD at a 3.25% interest rate, you would have earned $17,341.14.  So you made over $3,000 without taking on any risk.

What about taxes?

One reason the amount of $900,000 was used in the example, is that the current tax law only allows for home interest to be deducted on mortgage principal of $750,000 or less (if the mortgage was issued before the tax law in 2017, then it is grandfather in at a maximum principal value of $1,000,000).  So reducing the mortgage amount from $900,000 to $800,000 does not yield any immediate tax savings, and only starts to make any difference by the end of year 3 when the principal finally drops below $750,000.  If someone has a 40% combined federal and state marginal tax rate, the lost savings opportunity in the last 3 years combined would only be about $1000.  On the other hand, the CD interest would be taxed at 40% which would bring the after tax income on the CD down by almost $7000.  If the mortgage was below $750,000, paid down, and recasted (and you itemized your deductions on your tax return), then the tax impact on the mortgage recast would be similar to the tax impact on CD’s.  If the interest rate on the mortgage is higher than the interest rate on the CD’s, then there will always be a savings.

How is this different then just paying down your mortgage?

Typically, paying down your mortgage does not affect the monthly payments.  It only shaves time off your loan at the end and adjusts the proportion of money each month going to principal vs. interest.  Paying down your mortgage by $100,000 in this example would shave 4½ years from your mortgage, but you would not see any difference in the monthly payments.  They would remain at $4937.93.  Over the course of the next 5 years, you would spend over $33,000 more on the mortgage than if you had recasted it, but will also walk away with about $36,000 more at closing (because you have been making bigger payments each month and paying the principal down more).  So you do get the extra monthly payment money back plus $3000, but you miss out on 5 years of paying less each month.  You also miss out on using that extra $33,000 to invest in something else or even just have it earn interest in a CD or savings account.

Keep in mind that when you pay down your mortgage, typically the payment stays the same.  So you only see the benefit when you sell or refinance, or stop having to make any payments at all when the mortgage is completely paid off many years later.  Recasting your mortgage adjusts your payment right away.

Why not just refinance your mortgage?

The costs associated with refinancing can be staggering.  Everything from appraisals, to title insurance, to credit reports, to escrow fees, etc. — the list can go on and on.  It could be 1 to 3% of the loan amount or even more.  Obviously if interest rates had dropped notably or you qualify for a better rate now, it might still make sense to refinance.  But it generally doesn’t make sense to refinance into the same loan terms and interest rate when you can recast.  The beauty of recasting your mortgage is that many lenders will let you do it for very little money or even for free.  Chase charges a $150 fee and requires the principal to be paid down by $5000 or more.  Roundpoint Mortgage charges between $0 and $300 depending on the state.