The big news around the Heartland on FIRE household is that we closed this week on refinancing for our house. I wanted to take a moment and run through the process for the benefit of those that are considering refinancing. And for you personal finance voyeurs out there, stick around for the end where I will dissect our specific numbers.
Our Motivation
To kick things off, it’s worthwhile to note why we decided to pursue refinancing. I covered some of this in my recent post: Should I Refi?
Low Rates
My parents told me stories about double digit interest rates when they were looking for their first house. These stories have stuck with me. Interest rates have been hovering near historical lows and they happened to drop down again in June. Whenever I have a chance to reduce my borrowing costs, I am going to look into it.
To Eliminate PMI
PMI is Private Mortgage Insurance. It is required when you put down less than 20 percent of the home value when you purchase it. Under our old loan we were paying $108 per month in PMI… this is money that is simply lost with no benefits from principle pay down or earned interest.
PMI typically goes away once your principle balance drops to less than 80 percent of the home value. It also can go away if home values rise to the point where you owe less than 80 percent of the new value. With a red hot housing market, we found ourselves in the latter category
Reduce our Loan Term
A 30-year loan term, which is the standard mortgage arrangement, seems like a lifetime. Cut that in half to 15 years (which is what we did) and paying off the house seems like an actual possibility. A major benefit is that the amount of interest paid over the life of the loan is substantially less with the shorter loan term.
High Stock Market Valuations
With a 15-year loan term, we will be paying down debt much faster than with a conventional 30-year loan. A benefit of paying down debt, such as a mortgage, is that you can guarantee a return on investment (ROI) as the difference in interest paid between the longer and shorter term loans. However, a poplar perspective is that it is better to invest the money in the stock market because the returns are typically better than the interest savings. If that is true then why are we locking up our money with a higher mortgage payment?
If you pay attention to the stock market, you may have noticed that is seems pricey right now. A common way to evaluate whether the market is over or under priced is the Price to Earnings (PE) ratio. That is, the share price divided by the earnings of the company (or companies when looking at an index such as the S&P 500).
The Schiller PE method (named after its originator – Robert Schiller) is generally viewed as one of the best indicators of the market’s value. It is also referred to as the CAPE (Cyclically-Adjusted Price to Earnings) Ratio and it is based on the inflation-adjusted earnings over the past 10 years. The average Schiller PE over the history of the S&P 500 is 16.64 with a median value of 15.73. Higher PE ratios suggest the market is expensive, while lower values indicate it is on sale. At the time of this writing the S&P 500 Schiller PE is 33.44. That’s almost double the average! Want to check the numbers yourself? Steer your browser over to multpl.com.
There is always a market correction coming. It’s just a normal function of the stock market. Nobody knows when these corrections will occur… least of all me. This current bull market could run on for years, or the music could stop tomorrow. However, the PE ratio has been above average since 2010 and we have been experiencing one of, if not the, longest bull markets in history.
Anyways… in light of the high PE ratios, I think it is wise not to have all of our eggs (assets) in one basket. Paying down debt is one way to guarantee a return in the form of less interest paid and faster equity accrual (paying off the house). Equity in our home is only somewhat correlated to the stock market performance, so this offers some diversification when compared to a stock-only portfolio.
By no means take the above to mean I would avoid investing in the stock market. My wife and I max out our 401ks and Health Savings Accounts and are considering maxing out our Roth IRAs this year. Those funds won’t be touched for several years, so I consider the risk of market volatility to be worth it for the potential better gains.
We Don’t Plan to Be Here Forever
We like our current home, but neither of us consider it to be our “Forever Home”. At some point in time (7 years is a time frame we’ve discussed) we will likely move. We could save up for the next down payment, but conventional savings accounts won’t even keep up with inflation. We could invest in the market with hopes to make big gains, but the funds would be exposed to market volatility risk… not to mention taxable gains. However, paying down our principle may offer a best of both worlds scenario:
Low Risk – The only volatility is the home value. And if our goal is to purchase another house, then likely the price of the next house would be impacted by the same volatility, which makes it a wash.
Tax Benefits – The IRS will allow a tax free gain of up to $250,000 (or $500,000 when filing jointly with your spouse) when you sell a home you have lived in two of the last five years. Don’t take my word for it, venture over to the IRS website and find out for yourself. Tax free gains help offset the potential growth differential with money in the stock market.
The Refinancing Process
We started out comparing lenders to see who offered the best refinancing package. There are numerous websites that allow you to solicit multiple offers at one time. Simply google “Compare Refinance Options” and then let your fingers do the walking. Typically, you will be asked to enter the outstanding principle on your mortgage, your desired loan term, whether you want a fixed or adjustable interest rate, and your approximate credit score.
As it turned out, we ended up receiving the most attractive option from the lender we used when we bought our current house. From here on out the process was almost entirely digital. We started by completing an online loan application. This was a rather lengthy form which required mortgage statements, employment info, salary data, insurance info, and a reporting of assets and outstanding debt.
Once the application was submitted a number of back and forths ensued where we were asked to provide additional data (contact info for employment verification, rental income and HOA fees for our rental property, etc.). These requests were handled via email. We were then sent disclosures and good faith estimates via DocuSign. In the old days, this would have involved several trips to the lender’s office. Yay technology!
One of the major benefits that convinced us to proceed with the refinance was that our lender indicated they were receiving appraisal waivers so we shouldn’t need one. Since an appraisal is usually $400-$500, this was very appealing. However, once we got the good faith estimate, we noted that an appraisal fee was shown. When I called to question this, I was told that they “had to have that on there” and that an appraisal “would only be necessary in the event of a disaster”.
Welp, a week before we were to close, I received a call from the lender. They said that FEMA had declared our county a disaster area due to recent flooding and storms. As such, Fannie Mae and Freddie Mac (the folks that guarantee mortgages and allow lenders to sell them) had passed down word that all appraisal waivers would no longer be accepted in our area.
After being told by two folks at the lender that there was simply no way around it, that we would need to pay for an appraisal, my wife and I were very close to calling the whole thing off. This was due to our concern that an appraisal may not support a home value high enough to drop our PMI. Fortunately, later the next day, we received word that there was a work around for the issue where the lender simply took photos of our house.
Any who… after the appraisal situation was “resolved” we received a final quote for the loan and closing costs and a closing date was set.
At this point the “online” portion of the process was complete. We had to go to our bank to get a cashier’s check for the closing amount then drive to the title company’s office to physically sign the loan documents to make it official.
In classic Mr. Heartland on FIRE fashion, I made this portion of the process much more stressful than it needed to be. Namely, I forgot to transfer additional funds into our checking account to cover the closing costs. Doh! We had plenty of funds in our high yield savings account but it takes days to complete a fund transfer. Thankfully, we had juuuuuusssstttt enough cash in our savings accounts to cover our obligation. We will replenish the checking and savings accounts once the high yield transfer comes through, but I will be getting “low balance” warnings daily until then. Close call!
The Numbers
Our monthly mortgage payment will rise from $1,686 to $1,973 for an increase of $287. As I mentioned previously, we plan to sell in around 7 years. At this time, our principle balance will be around $58,000 less with the new 15-year loan than the previous 30-year loan. We will pay an extra $25,560 in mortgage payments over this time frame.
The total cost to close the loan was $4,761, which was composed of a wide range of lender fees, prepaid interest, property tax, and insurance. We will ultimately be refunded the escrow balance from our former lender within 30 days. We expect this refund to amount to $2,170. Additionally, we will skip the August mortgage payment. All told, our refinance has us out of pocket $905.
To figure out our ROI, we calculate our “return” as the increased equity (reduced principle balance) of $58,000. Our “investment” is calculated by adding our out of pocket cost ($905) to the increased payments ($25,560) = $26,465. Dividing the return by the investment gives us an ROI of 219% over 7 years. This calculates out as an annual return of approximately 12% Not bad!!
As you can see, we feel good about our decision to refinance. Now may be a good time to look into it yourself. Especially if you can lose the PMI payment in the process.
Thanks for reading!