Refinancing is the process of amending or revising your mortgage loan agreement, often resetting the interest rate, term length, and balance of your mortgage loan. There can be significant benefits to refinancing, such as lower interest over the life of your loan, improved cash flow and even debt consolidation. However, refinancing is not always the best the idea so here are a few things to consider.
1. Your current mortgage rate vs. the prevailing market rate.
- A basic goal of refinancing is to try to get a lower interest rate than the current rate on your loan. With rates at near all-time lows, there is a good chance that you can find a lower interest rate than what you are paying now.
- How much lower should your the mortgage rate be to consider refinancing? A rate that is lower by as little as 0.25% could be enough to justify refinancing. Consider shopping around with multiple lenders or using a mortgage broker to find the best rates.
2. Expected length of home ownership.
Assuming you can get a lower rate on your mortgage, refinancing makes more sense the longer you plan to keep your home. The reason for this is twofold.
- First, you will pay fees to refinance which could take several months to recoup. For example, if the refinance cost is $3,000 and you only save $30/month, it would take you over 8 years to recoup the cost of refinancing. Therefore, the longer you plan to keep the home, the more likely you will recoup the cost of refinancing. Keep in mind that the average stay in a home before moving again is around 8 years (create hyperlink- https://magazine.realtor/daily-news/2019/05/03/average-homeowners-stay-8-years-before-moving ) We prefer to see refinance costs recouped within 3-5 years. However, if you have found your “forever home” then even a slight reduction in rate, no matter how long it takes to recoup the fee, could make sense.
- Secondly, refinancing will temporarily damage your credit score. Your lender will make a hard inquiry on your credit report to judge your credit worthiness. Also, refinancing will reset the loan thereby lowering your average length of debt, a key factor that is used to calculate your credit score. Both of these things will temporarily hurt your credit score. If you plan to buy another home in the near future or apply for other debt, having a damaged credit score may prevent you from getting the best rate.
3. Monthly cash flow savings
Having free cash flow (money leftover at the end of the month after all your spending) is one key to building wealth as it allows you to invest in assets that grow your net worth over time. Mortgages are one of the largest expenses for households, so reducing your monthly payment can be a great opportunity. There a few ways refinancing can increase your cash flow:
- Lower Rate. As stated above, lowering your interest rate will result in a smaller amount of interest being paid and therefore more cash in your pocket.
- Lower mortgage balance. Even if you don’t lower your interest rate, reducing the loan balance with the same interest rate will lower your monthly payments. For example, if you had a mortgage of $200k that started 10 years ago, the current balance on the mortgage might be around $150k now. All else being equal, refinancing your mortgage on a $150k balance instead of a $200k balance will result in a lower monthly payment.
- Debt consolidation. Perhaps you have non-mortgage debt that is higher interest or a shorter term? Car loans, credit cards, home equity lines of credit, etc. Refinancing could allow you to take some of the equity out of your home (called a cash-out refi) to pay down these other, less desirable debts and improve cash flow. Your monthly mortgage payment would likely increase, but you might be able to pay off other more costly debts which results in a net positive impact to your cash flow.
- Longer loan term. perhaps you currently have a 15 year mortgage. Refinancing to a 30 year can result in a lower monthly payment even if the interest rate is higher. We generally prefer 30-year mortgages because of the lower payments that enable us to invest in assets that have historically high rates of return (or, if retired, KEEP assets with historically high rates of return). Even though the total interest paid will be higher on a 30 year loan compared to a 15-year, the monthly savings can be invested where you would expect to more than make up the additional interest cost.
Refinancing your mortgage can be a very powerful step that moves you forward in your wealth building goals. However, one final word of caution. Refinancing your mortgage does not help you build wealth in and of itself; it is what you do with the cash flow savings that will make a difference. Blowing the monthly savings on luxury items or vacations will leave you in no better financial position than if you hadn’t refinanced. Consider investing the cash savings in your 401k or brokerage account to reap the full benefits of refinancing your mortgage.
Partner & Wealth Manager CFP®, CIMA®, CPWA®, CEPA