TO REFINANCE OR NOT TO REFINANCE?
That is the question, but how to find the right answer? First things first – have your goals together. Mortgage Lenders are great at putting together loan options, but they are often times basing those options on what you tell them. If you are asking for the lowest rate, they will put those options in front of you, but surprisingly they may not always be the best options. Wait!? What, the lowest rate isn’t always the best option? Of course not – considering that the lowest rates are adjustable, or shorter loan terms with payments that may be out of reach for you. So, let’s look at your goals for the refinance:
Number 1: I WANT TO SAVE MONEY!
Everyone likes to save money – we like to save money! That’s why we’re writing this blog instead of mailing you a letter. Letters cost stamps! Let’s be more specific: do you want to save money now, as in lowering your monthly debt payments, or do you want to save the most over the term of the loan? Are you struggling to make the payments you currently have, or does your end of month surplus cash look like the US Treasury’s?
The best place to start is by looking at your budget. How much are you spending on all of your debt each month? Is that a high or low percentage of your monthly income? Do you have discretionary funds? Do you have a large amount of unsecured debt? How did you get to where you are and what changes need to be made to not get there again (if it’s not where you want to be)? Is your retirement savings on track? Having the answers to these questions before approaching a refinance is a great idea. Even better – meet with your financial planner before talking to your lender to help put these answers, and goals, together. Define what “saving money” looks like for you first.
Number 2: I WANT TO LOWER MY PAYMENTS
Debt isn’t much fun (well, it is for us, but for different reasons than you would think), but what it offers can be great. Mortgage loans are necessary for most people to own a home. We think owning a home is great! Auto loans are generally necessary to finance your transportation. Student loans – education. Credit cards? We’re not much of a fan of these. Using a credit card for convenience and paying off the balance each month? That’s generally a good thing. Credit cards are bridge financing if you carry a balance – the interest is costly and paying the minimum will take forever to pay off the balance. The point is: carrying the right kind of debt is ok, but eliminating the wrong debt is essential to your financial health. Sounds like we are talking about cholesterol here and the analogy works: having a mortgage loan is like HDL- your financial health is better with this kind of debt, but high a high credit card balance is like high LDL and puts your finances on the path of systemic failure. Refinancing offers an opportunity to right the ship, a “statin” for your system. By eliminating the bad debt and restructuring/lowering your monthly debt payments you can bring your finances to a better place. But beware – the last thing you want to happen is to combine all of your debt, lower your payments and then go on a spending spree. It’s important to take full advantage of the opportunity and create a sound financial plan to avoid adding the “LDL” debt again in the future. If your payments are reduced, plan to put some emergency money away and make sure you can pay off that credit card each and every month for good.
Number 3: I NEED TO FIX OR IMPROVE MY HOUSE
Construction loans, credit lines, fix up funds and often times local money is available in addition to your existing mortgage loan. Sometimes it doesn’t make sense to refinance your current mortgage just to get some money to put a new roof on the house. Look at the terms of your current mortgage and what is available from your lender. If the interest is going up on your current loan by more than what you would save on the construction financing portion, then just add the construction loan instead. Generally construction financing rates are higher than first mortgage rates, but if you are borrowing a small amount or your current mortgage has a much lower rate, then adding the secondary financing is a better option. If the construction project is larger, then it might make sense to refinance to a construction loan program like FHA 203k or Homestyle so that you can make the improvements and get a low, fixed rate loan for the project and your current mortgage balance all in one.
Number 4: I WANT TO LOWER MY TOTAL COST
Long term planners – this paragraph is for you. How much does the rate need to decrease for a refinance to make sense? If your other debt is in order, and your home is perfect as-is, then let’s look at break even points and a cost-benefit analysis. The absolute way to compare your current loan to a new loan is how much and how long. Take your current payment times the remaining term to calculate a total cost on your current loan. If the refinance option reduces that total number by an acceptable amount, by the same math (how much times how long), and the payment works, then it generally makes sense to do. Let’s look at an example:
Current principal and interest payment (exclude taxes and home insurance): $1200
Remaining number of payments on your loan: 280
Total cost: $336,000
New 15 year loan principal and interest payment: $1516
New total cost: $272,880
If the higher payment fits into your budget, this certainly makes sense to do if you are looking for long term savings. Even if the refinance costs $3,000, the savings is about $60,000 over the term. This is a common scenario right now for many 30 year loans with rates in the mid-4% range to refinance down to a 15 year term. You should also compare the total cost on your current loan if you simply increased the payment, but generally the refinance will add up to more savings.
The other calculation you need is the break even point. At what point in the future will I recoup all of the costs of doing the refinance? Two ways to calculate the break even offer manipulation of this time frame. One way to calculate break even is on the interest savings. If you save .625% in interest on the loan (reducing the rate by this much) and the refinance costs 2.375% of the loan amount, then it will take 3.8 years to recoup (ignoring time value of money and the decreasing benefit of interest savings over time). If you are a spreadsheet guru you could put this into an amortization table and calculate the exact break even by interest savings, but hey, life isn’t exact anyway. The other way to calculate break even is on a cash flow basis, but this isn’t as effective a calculation. If the monthly payment savings is $300 and the loan costs $6,000, then it will take 20 months to break even. The reason this approach is flawed is that you might be extending the term on your loan for this payment savings, which would potentially cost more in the long run. The simple formula here is: cost divided by benefit. That will yield the break even point. Have your lender help, and if they don’t know how to calculate this for you, then find a different lender!
Number 4: I WANT TO REDUCE MY TAX BILL
Mortgage interest is tax deductible. If you consolidate other debt that doesn’t have tax deductible interest, you could reduce your overall tax liability. Bring in your CPA and let’s have coffee with calculators. It’s great fun, and so is saving money! We think the government has enough to work with anyway, so why give Uncle Sam more than he has contracted for?
Number 5: I STILL DON’T KNOW WHAT TO DO
This likely has been more fun for us to write than for you to read about it. We are only going to complete a refinance for you if it makes financial sense to do so. Sure, completing loans is fun, but we need to make sure it is to your benefit. MN State law requires that the loan have benefit for you, and we’re you’re fiduciary, which means we need to look out for your best interests (no pun intended!). Bring your questions and scenarios to us and we’ll crunch numbers, calculate the savings, project long term costs, ask CPAs for tax analysis, talk with financial planners about retirement and other savings goals, and have you leaving our office more confident in your financial future. Maybe then you can spend more time working on getting that LDL lower instead of worrying about making extra payments on that credit card that seems to be stretching out to infinity.