Rarely does life provide us with second chances. But with major central banks around the world lowering interest rates and undertaking other measures to stimulate their economies, domestic interest rates have also dropped to levels not seen since 2012 and 2013. With the 30-year Treasury bond closing at a record-low yield in early February, Freddie Mac recently reported average rates of 3.59 percent and 2.92 percent for 30-year and 15-year fixed rate mortgages, respectively.
If you can qualify for a mortgage, it is an incredible opportunity to lock in low, long-term borrowing costs with a home purchase or refinance. If you missed the opportunity a couple of years ago or if your mortgage has an interest rate above 4 percent, it may make sense to consider going through the money-saving process.
The main factors to consider in your decision whether to refinance are how long you intend to keep the property, cost to refinance and monthly savings. The first issue may be the hardest to determine. Comparing the costs of refinancing with the monthly savings is relatively easy.
An estimate of the costs for a mortgage can be obtained online or from a lender. The three main cost categories include:
1. Lender fees to originate, underwrite and process the loan.
2. Attorney fees for title search, title insurance and closing.
3. Government fees to record the transaction in the land records.
The monthly savings is simply the difference between the monthly payment before and after the refinance.
With this information, you can calculate the “payback period,” which is how long it takes for the monthly savings to “payback” the cost of refinancing. You will have to wait until end of the payback period before realizing any savings. For example, with a cost to refinance of $3,000 and a monthly savings of $100, the payback period is 30 months (divide the cost of refinancing by monthly savings). If you plan to keep the property for more than 30 months, refinancing may be good idea.
Beyond monthly savings and the payback period, you should consider the total interest you would pay over the life of the new mortgage versus what you would pay on your old mortgage.
As with any financing, the lender will consider the three “Cs” of underwriting a mortgage in its decision about whether the risks are acceptable:
• Collateral — with an appraisal, the lender will compare the market value of the property with the amount to be borrowed.
• Creditworthiness — the lender will use the borrower’s credit report to review credit score, history and record of paying on time.
• Capacity — based on income, the lender will consider the borrower’s ability to make the payments. Generally, the lender will not want the borrower’s total monthly debt (housing expense and all other obligations) to exceed approximately 45 percent of gross income.
Another factor to consider when making a refinancing decision includes the impact on equity build up or principal payments. Extending the maturity of a mortgage usually lowers the amount of the monthly payment paid toward principal because more goes toward interest at the beginning of the mortgage. If you can afford it, you might want to consider a shorter loan period (e.g., 15 or 20 years). This may also be the best option if you have paid down 10 to 15 years of a 30-year mortgage.
In addition, don’t forget the tax implications. Although you may be saving money every month with lower interest payments, your savings may be less if your tax liability increases.
If you are fortunate enough to obtain a lower interest rate, another important decision will be what to do with the savings. Perhaps this would provide the perfect opportunity to establish or increase your retirement savings?
There are many variables to consider in the refinancing decision. Be sure to work with a qualified professional who can guide you through the options.
This article is for informational purposes only and is not financial, legal or tax advice. Please consult with your adviser before making any decisions.
David M. Taube, CFA, CFP is CEO and chief investment officer of Kalorama Wealth Strategies, LLC, a fee-only investment advisory and financial planning firm in the District. Reach him at 202-550-7262 or email@example.com.