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Should you refinance your mortgage?

Last time I wrote about whether you should buy or rent your home, and how to approach the decision. But what if you’re already a homeowner? What should you be thinking about?

Interest rates are extremely low right now. How low? Lower than they’ve ever been in my lifetime, and as low as we are likely to see them for a long time. That might not be all good news, but if you’re a borrower, there is definitely some lemonade to be made from the economic lemons we’ve all been handed.

A note before I begin though - I purposely left out this consideration in the buy vs rent analysis, because I think interest rates shouldn’t factor in to that decision - you should decide if buying is the right move for you based on other factors.

But if you’ve already got a mortgage, you probably have heard about the drop in rates, and are wondering if you should take advantage. There might be some terminology that doesn’t seem intuitive. And what about the rest of your debt? Let’s take a look.

Refinancing a mortgage is essentially like buying your home all over again, except you’re buying it from yourself for what you owe on the property. Let’s say you bought your home 5 years ago for $500,000, put 20% down, and took out a 30 year mortgage for $400,000 at 5%. Your monthly principal and interest payment is $2,147. You would have an outstanding balance on the mortgage today of $367,315. Let’s also say your home is now worth $550,000.

 Now, though, you can refinance your mortgage balance into a new 30 year loan for 2.75%, or even a 15 year mortgage for 2.50%. The new monthly numbers are tempting: your payment would be about $1,500, or about $650 less per month, with a new 30 year loan. If you go for the 15 year option, your payment increases to $2,450, but you will finish paying the mortgage 10 years sooner than you would with your current loan. So what’s the catch?

First, closing costs. You are applying for a new mortgage and have to go through the application process, and that involves fees. Some are bank fees, and some (like in NYC) are taxes paid on all new mortgages, even if you’re just refinancing - though you might be able to avoid that tax, depending on which bank you use. Those costs can either be covered out of savings, or you can roll some of them into the new mortgage, but that will affect the eventual payment.

Second, you are either resetting the clock (starting over with a new 30 year mortgage), or increasing your monthly payment for a faster payoff - either of these have to be considered in the context of your other plans.

Generally, a drop of .50% or more on your interest rate indicates you should at least consider refinancing. We can run an analysis of what you are likely to gain given the particulars of your situation, and the closing costs that apply to you.

A common question is whether to take a 15 year mortgage or a 30 year mortgage. Certainly, the idea of a paid-off home is very compelling for lots of people. And usually, the shorter the term of the mortgage, the lower the rate, so the less interest you’ll pay over the life of the loan. However, in most cases I still guide clients to a 30-year mortgage, and here’s why:

Let’s use the above scenario as an example. You take out the 30 year mortgage, but like the idea of paying off the home faster, so you make the same payment you would have with the 15-year. Extra mortgage payments shorten the life of the loan, and usually, there’s no prepayment penalty - you can accelerate your payments as you like. Instead of the required $1,500 per month, you pay the $2,450 that would have been your payment with a 15 year mortgage. If you do that every month, you will pay off the mortgage in 15 years and 4 months (the extra 4 months accounts for the small interest rate difference between the two).

But with the longer term, you have a lot more flexibility to re-direct those dollars. Kids need braces? Home renovation project coming up? Want to buy a new car? Start a new business? Or maybe someone suffers a temporary job loss. Your cash flow will have some room for that.

Also of note: you can pay down the mortgage faster, but should you? Mathematically speaking, probably not. Personal feelings about debt aside, if you can borrow at such low rates, it’s almost guaranteed that you’ll get a better return for the excess dollars in an appropriate portfolio of investments, provided you’re making consistent contributions. As noted in the buy vs rent post, one reason real estate becomes such an important asset is the forced savings aspect of paying that mortgage. Whether you pay down early or not, there needs to be a proactive plan in place for the non-mortgage dollars, including what you will do after an early payoff. Remember, your financial decisions have to align with your life goals!

Another term that you might have heard in the context of refinancing is the cash-out. In this type of refinancing, you “cash out” - borrow - part of your home’s equity. For example, as in the above illustration, your home is worth more than you originally paid for it. You own a bigger percentage of the house than you did before, and that’s an asset you can use: when you purchased it, your equity was the $100,000 20% down payment. But you’ve paid off part of your loan, and the house increased in value, so your equity is now $550,000 - $367,315, or $182,685. If you have high interest debt, it might be a very good idea to use some of this equity to pay off the higher rate debt. However, there are two big caveats here:

  • This is how borrowers and lenders got in trouble in the housing crisis - by over-leveraging their homes, or borrowing too much, and assuming the home value would always increase to compensate. It worked until it didn’t, and when the music stopped it caused a world of hurt. Try not to borrow more than 75% of the market value of the home, and make sure the increased payments from a higher loan amount still make sense

  • If you’re dealing with consumer debt, be honest with yourself about whether behavioral changes need to be made. Using home equity to pay off debt can be a great idea, but only if the debt won’t reappear.

So what if you’ve decided to pursue a refinance. What now? First, call your current lender and find out what they’ll offer you. Then, shop around for other options, starting at a site like Bankrate. When you have a few to compare, make sure it’s an apples-to-apples comparison, and you understand if you’ll be paying points (essentially, prepaying part of the interest up-front to get a lower rate), and what the closing costs will be for all. Start gathering documents - paystubs, bank and investment statements, and possibly tax returns will be requested. You will probably have to get, and pay for, a home appraisal.

If you’d like to review your situation and determine if a mortgage refinance might be a good idea, get in touch!


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