Refinance to Invest Payment Savings: Good Idea?

April 5, 2004, Revised November 17, 2004, June 29, 2007, Reviewed October 27, 2010

Refinancing a mortgage at a higher interest rate may be necessary to raise badly needed cash, or to reduce monthly payments you can no longer afford, but it will make you poorer in the long-term. That includes proposals to invest the savings in monthly payment, such as this one.

“I have a recently purchased home, with a $180,000 mortgage for 15 years at 4.63%. My new investment advisor suggests refinancing into a new 30-year mortgage at 5.85% to 6%, and investing the difference in payment. He says this will allow us to retire sooner. I am 61 and was planning on retiring at 66. I understand his argument but I hate to give up the ultra low 4.6% interest rate and the peace of mind of paying off the house sooner.”

Your investment advisor is either an idiot or a scoundrel. He is a scoundrel if the new loan he wants to put you into is one in which he has a financial interest.

On a $180,000 loan, the monthly payment at 5.85% for 30-years is about $327 less than at 4.63% for 15 years. Extending the term to 30 years reduces the payment by more than the higher rate increases it. Your investment advisor wants you to invest that $327, arguing that you will be better off down the road if you do.

You will be better off if the investment fund you accumulate over time becomes larger than the difference between the loan balance you will have at that time, and the smaller balance you would have had if you kept the lower-rate and shorter-term mortgage. For example, if you accumulate $20,000 after 5 years and your loan balance is only $5,000 higher at that time than it would have been, you would be $15,000 ahead.

In fact, there is virtually no chance of your coming out ahead. Over your time horizon of 5 years, you would have to earn more than 38% a year to make this happen. If you are in the 27% tax bracket, you would have to earn more than 24% after tax. If you hold to the strategy for 10 years, the required returns drop to 20% before-tax and 13% after-tax. These returns are still far higher than any available on investments your advisor can put you into.

I calculated these returns, as you can, from calculator 15a on my web site, Investing In a Shorter Term. The calculations ignore any refinancing costs. These would make the proposed strategy look even worse.

I have yet to find a legitimate exception to the following rule: "Refinancing into a higher-rate loan reduces your wealth." Read also Can Mortgage Refinance at a Higher Rate Make Sense?

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