Housing

Should You Refinance Your Mortgage?

If you are a homeowner with a freshly minted sizable mortgage or someone with a seasoned mortgage that you have been paying down for years, the question of whether you should refinance your mortgage probably pops up often.

There are several reasons homeowners consider refinancing their mortgage including, 

 i) taking advantage of a drop in interest rates

ii) paying down their mortgage sooner by moving to a loan with a shorter duration

iii) taking money out of one of their largest assets by doing a “cash out” financing

iv) because they are in a variable or interest-only loan and interest rates have started ticking up

Each homeowner’s motivation to refinance is going to be different based on their personal circumstances and the way their original loan is structured. If a homeowner has enjoyed low interest rates through a 5 year adjustable rate mortgage (ARM) and is quickly approaching year 6 when the interest rate will reset, there could be significant incentive to refinance to a fixed rate loan like a 15 year fixed mortgage or a 30 year fixed mortgage if interest rates are going up. After all, not many of us would like to wake up one day and find out that our latest monthly mortgage payment is $500 more than it was last month. In this situation, if your personal circumstances allow for it (a job with a steady income, money to pay closing costs if any, ability to handle higher monthly mortgage payments, etc.), refinancing into a fixed rate mortgage makes sense. 

If interest rates are going down or are stagnant, the variable rate actually plays in the favor of the homeowner. In fact, when governments in Europe cut their interest rates sharply after the last recession and their treasury notes ended up yielding zero interest or even negative interest, some homeowners with variable rate mortgages were pleasantly surprised to find that their lenders were now paying them interest for carrying their loans. See our article Why are mortgage rates pegged to the 10 year treasury note? to understand the role government bonds play in setting mortgage rates.

Following the COVID-19 situation and the aggressive actions taken by the Federal Reserve by cutting interest rates twice in less than two weeks, the current federal funds rate in April 2020 is near zero. Mortgage rates may not follow the fed funds rate to zero but it is possible that we might have a situation like Europe.

Fed Funds Rate April 2020
Fed Funds Rate April 2020

Another common scenario is of a homeowner in a fixed rate loan like a 30 year mortgage that is considering refinancing because interest rates have dropped since they got their mortgage. This is a more complex scenario where several variables have to be taken into account. The drop in the interest rate is just one consideration. Other factors include the length of time you have been paying the mortgage, the duration of the new mortgage, closing costs and whether you have to put money into the mortgage just to name a few.

Fixed rate mortgages are amortized, which translates into paying a lot of interest and very little principal in the early years. Towards the tail end of the mortgage, you pay very little interest and mostly principal.

To illustrate, if you enter,

  1. a purchase price of $500,000 in our mortgage calculator 
  2. a 20% down payment (translating to a loan of $400,000) 
  3. the loan rate as 4% and
  4. the term of the loan as 30 years

you will see from your first payment of $1,910 that $1,333 will go towards interest and just $577 of that first payment will go towards paying down the  principal of the loan.

By the time you get to the end of year 30 and make your final payment, just $6 of payment number 360 will go towards interest and $1,904 will go towards your principal. Hopefully, by then, your home has appreciated enough to offset the money you put into the 20% down payment, the income you could have earned on that capital over 30 years, the money you put into the home for repairs or home improvement projects, and last but not least the $287,478 in interest you paid on that $400,000 loan. 

With amortization in mind, if you are 7 years into a 30 year mortgage and decide to refinance into another 30 year loan, you would end up resetting the clock and will get into another mortgage where you will pay a lot of interest in the early years. You have to think beyond the lower monthly payment that a lower interest rate may offer and think about the total cost of the loan. 

To determine the difference between the current loan and the new loan, consider,

  • the total interest paid on both loans by using an amortization calculator
  • the closing costs associated with the new loan and
  • the difference in monthly payments between both loans

You could put that extra monthly savings into a certificate of deposit (CD), a savings account or an investment account. To get the full picture you also have to estimate how much that extra money could earn in the CD or investment account over the life of the original loan. One example would be to assume an annualized after tax return of 4% with a portfolio that is split into 60% stocks and 40% bonds and rebalanced periodically to maintain that 60/40 split. The 60/40 portfolio, for the most part, has been shown to work well and is often used by financial advisors to balance the risk of stocks with the steady (potentially lower risk) returns of an uncorrelated asset like bonds. 

For example, let us assume you purchased a home for $500,000 ten years ago and put 20% or $100,000 as your down payment. Further assume that the rate of interest was 4% and you got a 30 year fixed loan.

Mortgage Financing Example
Mortgage Financing Example

When you use the “Show me the calculations and amortization” option in our mortgage calculator, you will be able to see the amount paid each year towards the principle of the loan and the amount of interest paid.

Over the 10 year life of the loan, you would have paid $144,295 in interest and $84,864 of the principle. The remaining principle on that $400,000 loan would be $315,136. If at this time you refinance into another 30 year loan at a lower rate of interest (say 3%), your new payment would be $1,329 compared to $1,910 in the original loan.

This translates to $581 less in monthly payments. Assuming you put this money into an investment account that generates 4% after tax annualized returns, over the next 20 years, you would have $207,613 in that account. The remaining principle on your new 30 year loan would be $137,595. At this time you can use the money from your investment account and pay down the remaining loan if needed and come out ahead compared to the previous loan.

The short answer to the question of whether you should refinance your mortgage lies in a positive response to two other questions.

  1. Is the rate of the new loan sufficiently lower than the previous one, say at least 0.75% to 1% lower?
  2. Will you save the additional money from the lower monthly payments and invest it over the course of the loan instead of using it to lease the latest model luxury car?

If the answer is not affirmative to both these questions, it could be best to stick to the current loan and consider it a forced saving plan of sorts.

 

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