As mortgage rates continue to hit record lows, many people are refinancing their mortgages. Before you think I’m going to provide a definitive answer to refinancing, spoiler alert, I’m not, and there isn’t one.
Every situation is unique and driven by more than numbers. As much as we all want to believe we are rational creatures, many of our decisions are derived from emotions, not figures on paper. Before deciding to refinance, I’d answer two questions. Does the math work, and what does it allow you to do?
Does the math work is an easy question to answer. A simple spreadsheet provided by the mortgage broker, your financial advisor, or creating one on your own can give you an insight into the rational, numbers-driven answer. As you think through this question, here are three possible questions to ask yourself.
o What is the breakeven in years?
o Do I plan on staying in this home longer than my breakeven period?
o Is lowering my payment worth the added long-term interest?
A pitfall to avoid is believing you’re saving money on interest just because your rate is lower. Here’s an example where the math seems to work but doesn’t.
You buy a home and take out a $750,000 mortgage. After eight years, rates drop, and your mortgage broker calls saying he can get you into a 30-year loan at 3.5%. You look at the numbers, and everything looks great. A lower rate, a lower payment, and less total interest.
While it looks great, by refinancing, you end up paying more in total interest. The chart below shows the first eight years of your mortgage payments.
Then, the next chart shows the combination of both mortgages.
Total interest paid on your first mortgage would have been $618,050. Through your refinance, you’ve added $23,803 in interest payments. This happens due to the front-heavy interest payments on a mortgage. In this scenario, roughly 65 percent of the first year’s mortgage payments go towards interest. Monthly payments where the majority goes towards principal don’t start until year 10 of the loan.
o Do I have the cash flow to support an increased mortgage payment?
o What’s my long-term plan for this house?
o Will the increased mortgage payment derail my retirement plan?
Refinancing to a 15-year mortgage can significantly reduce interest paid. If timed right, it may allow you to be mortgage-free before retirement too. Let’s look at the same mortgage from above but change the second mortgage to a 15-year note.
The monthly payment is increased by $432 a month, and the total interest paid is considerably lower.
By refinancing, you cut seven years off your initial loan, reduce your total interest payments by $240,453, and only increase your monthly mortgage payment by $432.
What does it allow you to do?
By refinancing, you’re making mortgage payments for 38 years and increasing your interest payment by more than $20,000. That doesn’t mean you shouldn’t do it, though.
Being out of debt quicker doesn’t always mean better. By refinancing, you’re freeing up $950 in additional monthly cash flow. What does that allow you to do?
At a six percent return, investing $950 over the life of your new 30-year mortgage results in nearly $1 million. Are you willing to pay an additional $20,000 in interest for the ability to generate almost a million dollars? Or maybe it allows you to eliminate high-interest debt and contribute to your future goals. Whatever the additional cash flow will enable you to do, have a plan because lifestyle-creep is real.
Assuming your budget allows for a $432 monthly increase, and it doesn’t disrupt your retirement planning, the flexibility post mortgage can be remarkable.
If you bought your home at 30 and refinanced to a 15-year at 38, you’ll pay off your mortgage by 53. Had you planned on working until 65, that’s 12 years with $50,000 of cashflow you weren’t planning on having before the refinance.
With a 6% return, that could be an additional $1 million in your portfolio. It could also be a second home, an income-producing property, or a combination of all three. Maybe those things don’t resonate with you. Instead, the cash flow could provide an opportunity to donate to organizations important to your family, in a meaningful way.
Like I said at the beginning, no definitive answers here. Like most decisions in life, there is no right or wrong answer. We make decisions knowing that they aren’t the best or consensus ‘right’ answers, but we make them because they are what’s best for us at the time. If you can balance your rational and emotional decision-making process, “does that math work,” and “what does it allow me to do” you will likely make the best decision for you at that time.