In our 40+ years as wealth advisors, we’ve heard the question many times. Should I refinance? The reasons vary, but it typically comes down to saving more or getting out of debt sooner. Either way, our clients envision a better lifestyle and less stress as more cash becomes available for important goals like retirement funding, college savings for children, or living debt free. Of course, it can also be as simple as our clients spending some new found cash on the things they enjoy. Your reason might be something different still. Whatever the reason, the extra cash is a pleasant surprise.
So is it really worth the trouble? Typically, the monthly savings as a result of refinancing is a few hundred dollars. That doesn’t sound like much, but compounded over many years, the savings can really add up. A simple example may help. Imagine refinancing a $300,000, 30-year mortgage and lowering the interest rate from 4.5% to 3.5%. The savings is about $173 per month. Invest that savings and you could grow your investments to about $250,000 over 30-years. The mortgage is paid-off and you have an extra account that’s almost as large as the original mortgage itself. Not too bad!
Are you a good candidate to refinance?
Today’s process of refinancing a mortgage can be a bit tedious and time-consuming, so you shouldn’t charge headlong into the process unless it has a decent chance of paying off for you. Here are a few situations where a refinance might make sense.
- Your credit score has improved since you took out your mortgage.
- You have two mortgages (a first and a second) and consolidation could lower your rate.
- Interest rates are lower now than they were when you took out your original mortgage.
- Changing the structure of your mortgage makes more sense for you now (e.g. – locking in a fixed interest rate while rates are low).
- Your available cash flow has changed (e.g. – you can afford a 15-year payoff instead of a 30-year payoff).
Running the numbers — What are your options?
If you sense that a refinance may be worthwhile, you should probably start to look at specific numbers. The most common approach is to examine various mortgage alternatives with a breakeven analysis. In other words, how long it will take the projected savings from a refinance to offset the upfront costs involved. We typically look for a breakeven period of less than 5 years, but 2-3 years is really preferable.
There are some other factors to consider when preparing an analysis:
- Should you pay the upfront costs out of pocket or roll them into the new loan? The answer to this often depends on the availability of cash from other sources. Rolling the up-front costs into a new loan increases your debt level and affects the new monthly payment, but doing so may be the only option if other liquidity isn’t readily available.
- Is it best to restart the loan term, or pick-up where you left off? Here’s an example. Your mortgage has an original term of 30 years but only 25 years remaining until pay-off. Should you start a new loan with a 25-year term or should you reset it for 30 years? “Resetting” the loan term lowers the monthly payment more, but since the mortgage lasts longer, your total interest payments will be higher. The right answer depends on your personal situation, but resetting the mortgage term may provide more cash to save for retirement or other goals.
- Is a 15-year mortgage better than a 30-year mortgage? Like most of what we’ve discussed, the answer is “… it depends.” A 15-year mortgage means committing to higher monthly payments, but your total interest cost goes way down over the life of the loan. Does your cash flow support higher payments and does this trade-off appeal to you? You’ll be out of debt sooner, but remember that higher payments could shortchange your retirement savings or other goals. Over the long-run, you might be shooting yourself in the foot. Today’s interest rates are low, so combining a longer term, low rate mortgage with greater savings toward other goals often provides the best result. That said, becoming debt-free is very appealing to many people.
- I have a 30-year mortgage; should I make extra payments? You may desire to be debt-free sooner, but feel reluctant to commit to a 15-year mortgage with higher payments. You can work toward your goal of becoming debt free by making extra principal payments on your existing mortgage. (Generally, there are not pre-payment penalties when making extra payments, but you should confirm this). Making extra payments will shorten the life of a loan and get you out of debt sooner. You can make an extra payment each month and even modest dollar amounts can have a large effect. If you can afford it without shortchanging other savings goals, you can even pay your 30-year mortgage as if it had a 15-year term. This will get you debt-free sooner, but leaves you the flexibility to reduce monthly payments later if needed.
- What about an adjustable rate mortgage (ARM)? ARMs offer a lower interest rate than fixed rate mortgages, but the rates can adjust (higher or lower) after some period, usually ranging from 3-10 years. ARMs may be a good option if you don’t plan on staying in the same home for a long time. There’s more risk with an ARM since your interest rate (and monthly payment) can rise, but it can save significant money in the right situation.
What’s my next step?
Does it make sense to refinance? It is a short question with what can be a long answer. There’s quite a bit to consider. You should approach this diligently so you finish the process with the confidence that you have made a well-reasoned decision. We suggest you approach this systematically:
- Consider the examples mentioned above to confirm in your mind that you are a good candidate to spend some time on this.
- Assemble the current details on your existing mortgage. This would include the payoff balance, the monthly principal and interest payment, the interest rate, and the number of payments remaining. You should also have at least a ballpark idea on the market value of your home since this affects the evaluation of any new mortgage offer.
- Obtain guidance from a credible mortgage broker regarding what alternatives might be available to you as refinancing options. This will include rates, monthly payments, and terms. A reliable mortgage banker should not be captive to a single source of funds and should have access to a variety of funding sources to get competitive quotes.
Once you have your information assembled, you should lay out the payment obligations side-by-side in spreadsheet fashion. If you do not feel comfortable doing this on your own, seek the help of a financial advisor who will serve you as a fiduciary. In other words, someone other than the mortgage banker should help you make your final decision on what is in your best interest.
The comparison can be a quick conversation, but in other cases it may require some sophisticated number-crunching. Either way, you should invest the time required to make a confident decision about refinancing.
To learn more about Harold Williams, view his Paladin Registry research report.
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