The Wall Street Journal ran a big story on Wednesday about how homeowners are missing out on big savings because people can’t qualify for mortgage refinancings. This sounds like a tragic twist in what has been a humdinger of a bear housing market. But the more you understand mortgages, the more this bad news looks to be a blessing in disguise. To wit, the way fixed-rate mortgages are structured the lion’s share of your first decade’s payments are for interest payments, not to build home equity. Each time you refinance you reset the clock to zero, starting the interest-heavy period all over again. With the average homeowner mortgage lasting well less than 10 years before it is refinanced or paid off, it’s no wonder Americans are so lacking in home equity. I don’t mean to be insensitive to financially troubled homeowners who desperately need a break in their monthly payments, I’m just pointing out that there’s a big hidden cost to refinancing.
Let’s say you take out a $300,000 mortgage to buy a home. Assuming it’s a 6% fixed-rate 30-year mortgage you’ll wind up having paid $236,000 in interest by the half way point (15 years) but you’ll only have paid off $86,850 of your mortgage balance—that’s almost a 3-to-1 ratio of interest to principal. Put another way, by year 15 the banker has earned the lion’s share of his profit on the mortgage while you have eked out only a sliver of home equity. When I asked the Mortgage Bankers Association why the mortgage is so front-loaded with interest payments the response was that your loan is largest at the outset and it gets smaller as the years wear on, so interest charges should be larger in the early years. That’s certainly true and I would also imagine that banks need some extra booty to compensate for the risk that interest rates could skyrocket and they’d be left holding your 5% mortgage, perhaps for decades (although with securitization, nobody holds anything for very long). But all that said, from the homeowner’s perspective it’s not a great move to refinance unless you’re getting a huge interest rate-reduction. Home equity doesn’t just come from rising home prices (ah, remember that), it also comes from the unglamorous task of steadily paying down your mortgage.