Okay. So You've Refinanced Your Mortgage, Now What?

Okay. So You've Refinanced Your Mortgage, Now What?
by Richard P. Halverson

When it comes to subjects of finance and investing the general rule of thumb is, “If everyone is doing it -- it is probably a bad idea.” It is often true that the stronger the group-think mentality has the herd stampeding in one direction, the harder you should be running in the other. Refinancing mortgages may be an exception.

Mortgage rates have dropped to their lowest levels in many many decades. Unless you got your mortgage last week it is almost certain that today’s rates are lower than your current rate. You probably know this. It has been my experience that when it comes to mortgages the American home owning public that gets the mortgages is generally smarter than the large institutional investors that are buying them. In fact, you may wonder who it is that is doing all the refinancing advertising. Why would an institutional investor that currently holds your 8% mortgage want you to refinance for 6%? Well the investors don’t – but the middlemen do. A huge industry exists just to write mortgages. As you probably know getting a mortgage involves paying large closing fees. In fact, if it weren’t for all those closing fees we would all refinance every week. A lot of people make a lot of money on those fees. They’d love to see you refinance every week.

This article is not about how to refinance, it is about what to do after you have refinanced. However, if you have a mortgage and you are wondering about refinancing it may be worth your time to look at some numbers. There are some good calculators on the Internet that can help you get a general idea. One good site is www.quicken.com. Click “Home Loans”, “Refinance Center”. Here you will find a lot of information about the subject of refinancing. Click on the question “Should I Refinance?” to bring up the calculator. Run through the questions. (Incidentally, neither Meridian nor I have any relationship with Quicken.) Remember refinancing costs money in the way of closing fees. It is hard to give a rule-of-thumb but plan on 1% of the new mortgage amount as an initiation fee and $2,000 to 3,000 in appraisal, title searches and every other kind of miscellaneous fee you can think of. (As I said a lot of people are making a lot of money refinancing mortgages.) If your preliminary study indicates you can reduce your payments by refinancing then you should contact a mortgage broker in your area to review things in detail. You can find a mortgage broker on-line, in the yellow pages, from a friend or by responding to any of the countless ads you hear. Incidentally, there are many little tricks and considerable bafflegab in the mortgage business. Invest a little time to educate yourself and talk to a couple of mortgage brokers before signing anything.

Suppose you do decide to refinance your mortgage – now what? May I approach the answer to this in the following way? We have been counseled by our Church leaders to reduce our personal debt and that includes mortgage debt. Most of us need to borrow money to buy a home. Personally, I am grateful for the efficient mortgage markets that exist in this country. Those markets make it possible for so many ordinary citizens to own their own homes. It is part of the “American Dream.” However, I also believe it is very wise counsel to be conservative in assuming mortgage debt. It is a good goal to payoff mortgages as soon as possible. Refinancing can help you achieve that goal.

If you are just now considering refinancing your mortgage may I suggest the following temptations to avoid:

1. Do not stretch your refinanced mortgage out as far as possible. For example, if you currently have 20 years remaining on your original 30-year mortgage resist the temptation to extend your refinanced mortgage back out to 30 years – even though that will reduce your new monthly payments a little.

2. Do not borrow more than needed to complete the refinancing. You probably need to borrow enough to payoff the old mortgage and the closing costs. Beyond that resist the temptation to borrow more to consolidate other bills or to simply spend. You really do not want to spend 30 years paying for a trip to Disney Land as part of your mortgage. The exception might be needed remodeling. Increasing the amount of the first mortgage is probably better than getting a second mortgage for remodeling. But be conservative. It is possible the numbers on your refinancing are so attractive that you can easily talk yourself into a lot of home luxuries that are not all that necessary if you really think about them. It is good counsel to keep the luxuries on a buy-with-cash basis. Paying for them when you can afford them.

3. Do not use the savings in monthly mortgage payments for every day living. Resist the temptation to spend more on normal life style just because you are not putting the cash into a mortgage payment.

Here are three suggestions that I believe are consistent with the counsel to get out of debt and payoff mortgages as soon as possible. I am going to use the following example as an illustration. No two circumstances are alike.

Assume a family (or individual) bought a home 10 years ago. The original mortgage was for $200,000 at 8%. The monthly payment for principle and interest has been $1,467.53. After 10 years of payments the payoff on the original mortgage is $175,450. If the borrower continues to pay this mortgage for 20 more years they will pay $176,758 in interest. Assume mortgage rates are currently at 6%. Assume the borrower would need to borrow enough to payoff the original mortgage and $4,550 to cover closing costs for a new loan of $180,000. It makes sense to refinance this mortgage. Here are some options I suggest.

1. Maintain the same monthly payment and payoff the mortgage in less than 16 years.

The homeowners have been accustomed to paying $1,467.53 a month. They can get a new mortgage with a lower interest rate but the same payment and payoff their mortgage completely 4 years sooner than originally scheduled. In this case they will pay only $99,727 in interest compared to $176,758 they would have paid with the old mortgage.

2. Maintain the number of years at 20, reduce the required monthly payment and use the difference to pre-pay the mortgage.

The monthly mortgage payment will drop from $1,467.53 to $1,289.58 a month due to the lower interest rate. That is a savings of $177.95 a month. Since the homeowners have been accustomed to the higher payment they can add the $177.95 to their regular payment each month and pre-pay their mortgage. This has essentially the same effect as option #1. That is if they are consistent they will payoff their mortgage in just under 16 years. The difference with this option and option #1 is flexibility. The owners are not required to make the extra payment. They will not be in arrears if they choose not to. So the question for the owners is one of financial discipline. If there seems to be some other need for the money every month they will not payoff their mortgage early or improve their overall financial health. Incidentally, if the owners do not pre-pay the loan the interest on the 20 year mortgage will be $129,497 nearly $30,000 more in interest paid to the bank than by paying the mortgage off in 16 years.

3. Maintain the number of years at 20, reduce the required monthly payment and invest the difference.

The owners’ monthly payment declines from $1,467 to $1,289.58 in this example. As an alternative to plowing the $177.95 back into the mortgage they can invest the difference. (A purest would argue that when options #1 and #2 are available this amounts to borrowing against your house to invest in something like stocks. Conservative financial advisors will not recommend this.) However, this option can make sense in some cases. It makes most sense if the owners’ current cash flow restrictions make it impossible to take full advantage of all the tax-advantaged investments available to them such as IRA’s and 401k’s. Putting this freed-up cash flow into a 401k can be particularly attractive if your employer has a program for matching it.

There are a number of variables in this option that make giving simple examples of how this might work difficult. Whether this owner’s total financial well being is better with option #3 sixteen years from now (the payoff in option #1) depends on many things. For example, their discipline in investing, rather than spending, the difference. How well they invest is key. Additionally, taxes are an important consideration. Interest paid on the mortgage is tax deductible while earnings on the investment are tax payable. Taxes are the reason why investing-the-difference is more likely to be a good alternative if the investment is going into a tax advantaged account.

Declining interest rates have given many homeowners a windfall. If you have already refinanced or plan to refinance to enjoy that windfall I encourage you to use it to improve your overall long-term financial well being rather than simply spending the windfall on today’s whims. I believe that home ownership is still part of the “American Dream”. However, it does seem the idea of actually owning the home, i.e., paying off mortgage, is fading in some of those dreams.

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