If your credit score is currently 700+, that’s a hopeful sign. That being said, it still does not look to me like aggressively paying it down is necessarily your best move. I’m going to do some rough guesstimates and math below that someone can correct if they think correction is required, but here’s what it looks like to me. Long story short, it makes WAY more sense to find a contractor who isn’t on crack (i.e., isn’t estimating $200k) and use the money you would otherwise spend paying down the mortgage to build a third unit. Either that or invest in an index fund. Skip to the end if you want to see why.
So, you currently owe $885k on a house you bought on a 40-yr adjustable mortgage in 2006, which is currently at 3.25%. (I’m guessing this means you bought it for about $1 million in ‘06). You are thinking of refinancing in late 2015. Let’s call it 2016 just to make a nice round number, ten years from when you bought it. At that point 30 years will remain on your original 40-yr mortgage. So basically, you have two years until refi. How much can you pay down the mortgage in two years? Just by regularly paying your mortgage between now and then you should pay off about $30k, bringing you down to $855k. But let’s say you get very aggressive and manage to pay off an additional $100k over the next two years. So, $755k is where you’re at when you have to refinance.
How much money does that save you? Let’s run the numbers with some possible interest rates (note that I am *not* adding the half a percent or so that you will get whacked with for needing a jumbo loan—that is something to factor in; loans over $650k have higher interest rates):
- $755k at 4.5%: a 30-year mortgage would be $3825/mo, not including property taxes or insurance, and would cost you just over $622k in interest if you took the full 30 years to pay it off. A 40-year mortgage would be $3394/mo and would cost you just over $874k in *interest alone*. This is important: look at how much it costs you to go with a 40-year rather than a 30-year mortgage! Over $250k, even at this low interest rate! (Not to mention, a 40yr loan will have a higher interest rate than a 30-year, just as a 30-yr has a higher one than a 15-yr—I’m just using the same rate in these examples for easy math.)
- $755k at 5.5%: 30-yr, $4287/mo and just over $788k in interest. 40-yr, $3894/mo and over $1.1 million in interest.
- $755k at 6.5%: 30-yr, $4772/mo and just under $963k in interest. 40-yr, $4420/mo and almost $1.4 million in interest. So going with a 40-yr rather than a 30-yr would cost you almost half a million bucks.
Let’s compare that to where you’ll be if you just keep paying your mortgage normally. In 2016 you’ll have a mortgage of about $855k, with 30 years left on it, at whatever the interest rate adjusts to then.
- Let’s say it’s 4%. That would put your monthly payment at $4082, or about $250/mo more than if you pay it down to $755k and refi at 4.5%. (Remember, you’re not going to refi at a better rate than what your mortgage will have adjusted to—a fixed-rate mortgage is always going to have a higher interest rate than an ARM that’s available at the same time.)
- At 5%, the $855k would give you a monthly payment of $4590, or about $300/mo more than if you paid it down to $755k and were able to refi at 5.5%.
- At 6%, the $855k would give you a monthly payment of $5126, or about $254/mo more than if you paid it down to $755k and were able to refi at 6.5%.
So as you can see, paying your mortgage down aggressively—to the tune of $50k a year on top of what you’re already paying down with your regular mortgage payments—would only reduce your mortgage payment by $250-$300 a month. So you would have spent $50k a year for two years in return for saving somewhere between $2700 and $3600 a year. That is a return of only 5.4%-7.2%. It’s great compared to a CD or a savings account, but that return will be temporarily wiped out by the cost of refinancing: 1% loan processing fee (so… like $7500!), application fee and doc prep fee (another $1000 probably), points, appraisal…
I would think bare minimum your refi would cost around $10k, which would wipe out 3-4 years of the savings on monthly mortgage payments. Which means that somewhere around 2019-2020, you would actually start saving money… to the tune of $250-$300/mo. In other words, between your 2016 refi and let’s say 2026, your average ROI, in return for all that aggressive paying down of your mortgage, would be equivalent to about $1800/year, or 3.6%.
So personally, no, I wouldn’t sink $100k into the mortgage over the next two years. I would probably put that money in an index fund, which, chances are, is going to do much better than 3.6%, and if there comes a day when it’s clear that staying in that house is the best move for you guys, then maybe you can take a lot MORE than $100k out of that index fund and throw it all at the mortgage at once.
Or as an alternative, you can call some contractors who are NOT on crack and get a REASONABLE quote for adding a 1BR/1ba to your house or garage (don’t mess with the bedrock!). I know it’s not properly zoned for a third unit, but I also know some Bay Area contractors could not care less; they’ll build it nicely and to code (electrical/plumbing code) without permits. Or just get a permit for adding a bedroom and bath to your existing house, and when the inspector is gone, throw up some drywall to separate the new unit from the downstairs unit. That would add a cool $1500 (or whatever 1BR’s rent for in your neighborhood) to your monthly income. Let’s say it cost $100k to do that and took six months… you would then have an extra $9k in income this year, and an extra $18k for every year to come—an ROI of 18% a year. Obviously far superior to an ROI of 3.6%! And if you’re concerned that one day you might want to sell or refi and the illegal third unit might complicate the appraisal, build it so that it’s easy to reconnect it to your ground floor (all you need are stairs and a door), and you’re ready to refi or sell.