By Mike Hathaway, CFA®
“Should I refinance my mortgage?” This is a question I hear frequently from clients, friends, and family. It has been happening more lately with interest rates having come down so low—and now that inflation is threatening to increase them once again. Before we begin, a disclaimer: I have no idea whether interest rates will be higher, lower, or the same a week from now. Or a month from now. Or a year from now. None of what I am about to say depends on knowing future mortgage rates. Whether or not someone should refinance a mortgage depends primarily on one’s goals and objectives for refinancing the mortgage, and on the values of a few key variables.
Consider the Variables
Let’s first address the variables. There are four key variables related to mortgages:
Annual interest rate, expressed as a percentage (these are currently very low): “Points” are not really a separate variable; instead, they are a factor in determining the annual interest rate that will be paid, primarily by “pre-paying” some of the total interest up front, at the beginning of the loan.
Principal: This is the amount remaining on the current mortgage unless the borrower chooses to “roll in” the closing costs on the refinancing into the new mortgage. The borrower might also use some external funds to reduce the principal amount, although this is less common. Principal amounts over a certain level are called “jumbo” or non-conforming loans. The limit for conforming loans is set annually by the Federal Housing Administration (FHA), and in 2020 was $510,400 for a single-family home (or $765,600 for designated high-cost areas). (1) The advertised interest rates for jumbo mortgages are usually slightly higher than for conforming mortgages.
Term, measured in years, for how long the mortgage loan will last: Common mortgage terms are 5/1 (adjustable), and 15 and 30 years (fixed).
Monthly payment amount: This is determined in such a way that the loan is “fully amortizing,” meaning that the monthly payment amounts will stay constant through the life of the loan, and will include both principal and interest components.
To amortize fully, the interest component will be a larger fraction of the monthly payment in the beginning years, and a smaller fraction in the later years of the loan.
What About Points?
Before discussing how the key variables above work and are tied together, let’s first tackle the subject of “points,” and whether a borrower should pay them. As mentioned above, points are simply “prepaid interest,” and the points are paid up front in exchange for a lower annual interest rate over the life of the loan. The borrower must have access to outside cash to pay the points up front, but this will pay off over time. This is known as the “breakeven period.” To simplify, if a borrower has access to the outside cash needed to pay the points and intends to stay in the mortgage (not just the home) longer than the breakeven period, the points paid up front provide a net financial benefit to the borrower.
Although there are four variables above, you don’t get to choose all of them! Based on the borrower’s choices (principal amount and term), lenders will quote a variety of rates (with and without points). Once the lender and rate are chosen, the monthly payment amount will be determined. In simpler terms, once the borrower has determined the principal amount, the other three variables are linked together according to a mathematical relationship (rate, term, monthly amount). There are numerous mortgage and financial calculators available on the internet for borrowers to compare their options.
Determine Your Goals
What is usually more important to advisors working with clients looking to refinance their mortgages is to understand the motivation—goals and objectives—for the refinance in the first place.
Some common goals for refinancing include:
- Getting a lower interest rate: If rates have declined enough from the time the mortgage was put in place originally to cover the costs associated with refinancing, this should save the borrower money, in the form of paying less total interest over the life of the loans. This is especially true if the borrower can pay points to decrease the annual interest rate even further.
- Paying off the mortgage sooner than originally scheduled: If this is the case, then the borrower must choose a new mortgage term that is shorter than the years remaining on the original mortgage. This will usually result in a higher monthly payment amount (depending on the actual change in term and annual interest rate), but with a decrease in the total amount of interest paid over the life of the loan.
- Reducing the monthly payment amount: In this case, there will be a tradeoff. Usually, the term of the new mortgage will be longer than the original term remaining, and the total interest paid over the life of the loan will also likely increase. This decision should be made with caution and understanding of the tradeoffs.
In the context of an overall financial planning relationship with our clients, we often see that the clients’ financial situation has improved since the original mortgage (or the last refinance). They are often able to afford a higher monthly mortgage payment, and in exchange for absorbing the costs of refinancing, many can significantly shorten the term remaining for mortgage payments and reduce the total amount of interest they pay over the life of their mortgages. This can free up cash flow for other priorities—allowing for greater spending, investing, or more flexibility in the overall financial plan.
We’re Here to Help
As in all financial matters, you should investigate carefully before you act. If in doubt, you should seek professional advice from a fee-only, fiduciary financial planner. We at Epsilon Financial Group help our clients make sound financial decisions and solve complex financial matters such as this one, and we can help you too. Email us at Mike@wealthmatters.com, Mark@wealthmatters.com, or call (707) 428-5500 to get started.
Mark is President and founding principal of Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. With over 35 years of experience, Mark strives to help his clients make sound financial decisions and navigate complex financial situations. Mark is passionate about providing services that add value to his clients’ lives and help them achieve financial peace of mind as they pursue their goals. He is known for his extra efforts and first-class service on behalf of clients. Mark has a bachelor’s degree in engineering from the U.S. Air Force Academy and an MBA in finance from the University of California, Berkeley. He is an Accredited Investment Fiduciary Analyst (AIFA), Certified Investment Management Analyst (CIMA®), Certified Investment Management Consultant (CIMC), and CERTIFIED FINANCIAL PLANNER™ (CFP®) professional. To learn more about Mark, connect with him on LinkedIn.
Michael Hathaway is a fiduciary financial advisor at Epsilon Financial Group, Inc., an independent, fee-only wealth management firm. Mike has worked in the finance industry for more than 20 years and brings a wealth of knowledge and experience in sophisticated financial planning to help his clients make sound financial decisions. He is known for caring deeply for his clients’ well-being, being compassionate, and thinking creatively to help clients attain their financial goals. He prioritizes building long-term relationships and takes the time to listen, understand, and explain so that his clients feel confident in their financial plan. Mike is a CERTIFIED FINANCIAL PLANNERTM, a Chartered Financial AnalystTM, and an Accredited Investment Fiduciary®; he has a bachelor’s degree in cybernetics from UCLA and an MBA in finance and accounting from the University of Virginia. When he’s not working at Epsilon, you can find Mike enjoying anything related to exercise and fitness. He especially loves activities in the great outdoors, such as mountain biking, camping, hiking, and snowshoeing. In the fall of 2016, Mike successfully climbed to the top of Mount Whitney in a single day, the highest peak in the continental United States. To learn more about Mike, connect with him on LinkedIn.