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Mortgage Q&A: Low rates offer options for payoff

Q. Six months ago, we refinanced our home for what we thought was the absolute last time. We took out a 10-year fixed-rate loan at 3.25 percent and paid no fees. My wife and I are now thinking we may have made the wrong decision.

Our loan balance is $260,000, and our home is worth at least $600,000. We both are retired and have a secure, fixed retirement income.

Our financial adviser suggested that because rates are so low, it may make more sense to hold a mortgage longer instead of paying it off in 10 years. He said we can earn a better return than the cost of a mortgage these days.

The plan sounds appealing, but owning our home free and clear also is appealing. Thoughts?

A. My answer is always the same: There’s never one right answer. It all depends upon your objectives.

Paying off a mortgage by reducing the term to just 10 years is certainly a good objective. But your financial adviser also is correct. Mortgage rates are incredibly low, and he may, indeed, be able to earn a better return than the cost of your mortgage, especially if the investment has a minimum 10-year horizon.

Without going into numbers pulled from a calculator, let’s look at the scenario from a broad perspective. Your investment adviser is suggesting that his investments of your money will earn a higher annual return than the cost of your mortgage, which is 3.75 percent.

He’s probably right. While even the most conservative investment portfolios vary from year to year, an average annual return of more than 3.75 percent over a 10-year period shouldn’t be that hard to attain.

If you refinance to the 30-year fixed rate of 3.75 percent and make the minimum principal-and-interest (P&I) payment of $1,204 per month, your loan balance at the end of 10 years will be about $203,000. Your existing P&I payment under the 10-year fixed-rate program at 3.25 percent is probably close to $2,540 - a difference of $1,336.

Your investment adviser is suggesting that you refinance to the 30-year loan, lower your monthly payment by $1,336, and use this payment difference for him to invest each month. At the end of 10 years, if he can attain an average annual return in excess of 3.75 percent, the balance of the portfolio will exceed the $203,000 mortgage balance.

This practice is known as arbitrage, which means you essentially are borrowing money at one interest rate and earning a higher rate by investing it. The difference is your profit.

There is risk, of course. If your average annual return over 10 years is less than the cost of your mortgage, the value of your investment will be less than the balance of your mortgage. With fixed rates so low, however, your adviser is betting that the investment markets eventually will recover and start earning some higher returns while the interest rate on your mortgage remains fixed at 3.75 percent.

Interest rates are at rock bottom. You have a ton of equity in your home. You also have continuous retirement income. These circumstances suggest your adviser is giving you good advice.

Henry Savage is president of PMC Mortgage in Alexandria. Send email to henrysavage@pmcmortgage.com.

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