Should I ReFi?

With interest rates so low, we have been considering refinancing our home. Since I am the proud owner of this nifty blog I thought it would be a great place to walk through the refinancing options and considerations and to show our thinking using our situation as a case study for others to compare to.

Why Refinance?

Lower Your Interest Rate

The major benefit is to lock in a lower interest rate. With a loan term of 30 years, a slight reduction in the interest rate can have a large impact. As an example, our current interest rate is 4.125%. At this rate we would pay $179,000 over the 30-year life of our mortgage. That is more than 70% of the purchase price of our home! Proof that compounding is a real B*&CH when it’s working against you.

Change Your Mortgage Term

When you refinance you don’t need to stick with the same loan term. Some, like us, may want to consider reducing the term to 15 or 20 years. Doing so has two benefits. The shorter term typically carries a lower interest rate and the shorter payoff builds your equity much faster.

On the flip side, some people choose to refinance into a longer term. A real estate investor may purchase a house with cash obtained from a hard money lender. These type of loans typically have high interest rates and very short terms… on the order of only a few years. A refinance into conventional 30-year mortgage would allow the investor to pull out their equity and pay off the hard money loan.

Change Loan Types

Mortgages can either have a fixed rate or an adjustable rate. The latter is often referred to as an ARM. Additionally, some mortgages could have a “balloon” payment at the end. This is when there is still principle that is due at the end of the loan term. This larger principle balance becomes due all at once. By refinancing into a fixed rate mortgage, borrowers can gain protection from variable interest rates that could rise in the future as well as avoiding a balloon payments.

Drop Private Mortgage Interest (PMI)

PMI is typically required when the loan amount is greater than 80% of the value of the property. If the value of your property has risen, or if your loan balance has dropped near that threshold, or both, then it may be possible to eliminate your monthly PMI payment.

Now, to be clear, you can drop PMI without refinancing by paying down your principle balance to less than 80 percent of the home’s value, or by getting an appraisal that shows the home’s increased worth. A couple examples: If you bought a house for $100,000 that was valued at $100,000 then your PMI would drop when your principle balance reached $80,000 or less. Alternately, let’s say the real estate market was hot and the home value increased to $125,000. The loan to value ratio is now $100k/$125k = 0.8 (or 80%). If you could prove the increase, like with an appraisal, then you could also drop your PMI.

Getting Your Equity Out of Your Home

This is also referred to as a “Cash Out” refinance. In this situation you have a certain amount of equity built up in your house and refinance the house for more than you owe. The difference between the new loan amount and what you owe comes back to you as liquid cash. Some people use this for remodeling, or investing.

Considerations To Keep in Mind

Does Your Goal Align With Your Overall Plan?

I’ve outlined several possible motivations for refinancing above. It is important that you understand what your desired outcome is and to make sure it fits with your overall plan. For instance, it does not make much sense to refinance from a 30-year to a 15-year mortgage with a higher monthly payment if you have outstanding high interest debt. Or if you haven’t maxed out your tax deferred investment vehicles.

Flexibility/Liquidity

If you are reducing your loan term you are committing to locking up a larger amount of your income for the foreseeable future. Are you comfortable with your finances and believe your income is steady enough to warrant this loss of liquidity? Do you see any major monetary needs that you would have a hard time covering? If so, then reducing your loan term may not be a good fit.

Closing Costs

Refinancing is not as simple as snapping your fingers. The lender has to generate the loan and due their due diligence. This takes time and; therefore, money. Typical fees include loan origination costs, underwriting fees, appraisal costs, credit reporting fees, and more. These fees vary depending on the size of the loan and your location. Average closing costs for a $200,000 loan are in the vicinity of $2,000 according to Bankrate. If you plan to hold on to the house for several years you should be OK; however, if you want to move in the next few years, you may not be able to recoup the closing costs.

Opportunity Costs

If you reduce your loan term, chances are you will be increasing your minimum monthly payment. This locks up money that could be invested elsewhere. So, you are missing out on the potential investment growth of this money. I always recommend calculating your opportunity costs based on what the money would earn in a passive investment vehicle, such as the stock market or bonds. Typically, this calculation is done using an online investment calculator, or my own spreadsheet. An example of how I approach this is shown in the case study below.

A Case Study: Our Home

As I mentioned previously, my inspiration for writing this post is because we have been weighing the option to refinance. Specifically, we are looking to refinance to a 15 year term to get the lowest interest rate possible.

First, let’s look at the numbers

Here is some baseline data on our existing mortgage:

• Existing mortgage amount and rate: approx. $225,000 at 4.125%
• Purchased for $254,000 4 years ago.

Potential Refinance Scenario:

• Current home value: Estimated at $289,000. (based on comps across the street)
• Based on the estimated new value, our loan to value ratio will drop below 80%; thus PMI will be dropped
• Refinanced loan term and rate: 15 years at 3.375%
• Quoted closing costs: capped at $2,000
• Likely holding period for our house: We expect to move again somewhere between 5 and 10 years… let’s call it 7 years

Ok, now based on the info above, let’s take a look at the numbers. I plugged both our existing mortgage info and potential refi info into a loan amortization calculator (one I’ve built myself, but there are several freely available online). Based on the above assumptions, I get the following numbers after 7 years:

	30-Yr (as is)	15-Yr Refi	Difference
Principle Balance	$190,905.03	$133,000.00	$    -57,905.03
Monthly Payment*	$1,686.00	$2,003.04	$          317.04
Interest Paid	$60,845.14	$42,957.24	$    -17,887.90

*Including principle, interest, taxes, and insurance (PITI)

One note, the $317 is a bit misleading. Our PMI payment will drop off automatically sometime during he last 3 years of the 7-year window. As such the average increase in mortgage payment over the term is $363 or $30,519 additional in monthly payments over 7 years.

Nearly $58,000 in equity over our current mortgage. Subtract the additional monthly payments (30,519) and the closing costs ($2,000) and the net benefit appears to be $25,325. That is roughly a return on investment (ROI) of ($25,325/$32,519) = 78% or an annualized return over 7 years of 8.6%.

But not so fast my friend! Let’s not forget about opportunity costs! If we invested the $2,000 intended for closing costs and difference between the current and refinanced mortgage payments (average of $363, monthly) and were able to secure a 6% return, the growth would be equal to $8,073. (I used this investment calculator for this, and keep in mind that I am not accounting for taxes here). So we are comparing a return of $25,325 with the Refi to $8,073 from an investment option. There is also substantially more risk involved in the stock market investment option.

That ROI of the Refi Option looks very attractive for what is essentially zero risk.

But what about the other considerations?

If a higher mortgage payment is at the edge of sustainability for you, then refinancing into a shorter term is probably not for you. Thankfully, both my wife and I work full time jobs and are blessed with good salaries. As such, we can make both ends meet with the higher mortgage payment even in the event that one of us loses our job. Additionally, we have established an emergency fund to cover several months expenses in case of a major disaster.

High interest debt, company matching on 401k and tax advantaged investments are low hanging fruit and should be addressed before attempting to refinance. The debt will eat you alive and the latter options represent free money. We have the existing mortgage, one small car loan with a very low interest rate (to be paid off in 6-8 months), and a mortgage on our rental property (previous primary residence) that is covered by the tenant’s rent. Beyond that, we are debt free. We are currently maxing out our 401k contributions and Health Savings Accounts (HSAs). We aren’t maxing our Roth or Traditional IRAs; however, our income is above the deductible threshold for a Traditional IRA. In summary, we don’t have any high interest debt and there is not a lot of allowable tax advantaged investment room left.

We are currently paying PMI on our existing mortgage. This refinance should do away with the PMI and redirect about $108 to principle pay down.

Since we plan to move sometime in the future (best guess is 7 years) we plan to harvest the additional equity from the 15-year loan term when we sell. This is essentially a play for reduced taxes in that the IRS allows for up to $250,000 in profit from the sale of your primary residence (or $500,000 if married and filing jointly) tax free. You must have lived in the home for 2 of the last 5 years and have not claimed the exclusion on another home in the past 2 years.

A similar investment in the stock market would be taxed at our capital gains rate, or possibly ordinary income rate (depending on timing), which would likely be 15% to 24% for us. Going back to our case study, capital gains tax would likely reduce our investment growth of $8,073 by $1,210.

In Summary

Refinancing is not necessarily the best option for everyone; however, after running our numbers and thinking through these considerations, we are strongly leaning towards the refinance. So what do you think? Am I overlooking some pros and cons? Any tips or tricks to capitalize on a refinance?