When Is the Right Time to Refinance?

“When is the Right Time to Refinance?” is likely one of those questions that never have a straightforward answer.

Accurately answering this question is challenging because several factors must be considered to make a prudent financial decision.

The refinancing process simply means replacing an existing mortgage lien with a new mortgage lien that likely has different terms (usually more favorable in one way or another) from the original mortgage loan.

There are four primary reasons to refinance a mortgage –

1. A borrower reduces the interest rate and saves money each month as well as over the life of the loan.
2. A borrower chooses to reduce the term of the loan, which saves years of payments and, thus, significant money over the loan’s life.
3. A borrower converts their Adjustable Rate Mortgage (ARM) to a Fixed Rate Mortgage (FRM), reducing the uncertainty of the number and monthly amount of future mortgage payments. A refinance such as this is quite valuable to many borrowers.
4. The borrower needs to pull out equity from their primary residence –
   1. To pay off or consolidate high-interest debt – like credit cards or personal loans, etc.
   2. To obtain funds for emergency purposes, like unexpectedly needing a new air conditioning or heating unit.
   3. To obtain capital to upgrade the property with energy-efficient home improvements or an addition.
   4. To obtain capital to pay for college tuition or trade school, etc.
   5. To obtain capital to open a business, to name just a few reasons.

Outstanding Mortgage Debt

According to statista.com, in 2019, the total debt outstanding for residential properties (one to four families) exceeded 11 trillion dollars. The graph below depicts the amount of total mortgage debt between the years 2001 and 2019 – an increase from $5.6 trillion to about $11.1 trillion – which is essentially a doubling of outstanding mortgage debt

With mortgage debt reaching peak levels and mortgage rates dropping to at or near historic lows – there is a lot of mortgage interest to be saved during the unusual economy facing homeowners during the early part of the year 2020.

A Word About Qualification

As most borrowers know, every lender sets forth a certain set of standards upon which they judge a mortgage approval. People in the business refer to these preset loan standards as underwriting guidelines. These guidelines, which change from time to time, reflect economic and real estate market conditions and are used to determine if a borrower’s financial/real estate situation meets the lending requirements by that specific lender.

Each lender has the authority to establish the lending criteria for approval for mortgages funded through its proprietary pipeline. However, every lender also has the option to allow for exceptions that could be included in a mortgage approval.

Let’s review these refinancing options in detail.

Refinance Option #1 – Reducing the Current Interest Rate to Save

Most people begin to consider refinancing when they become aware that current interest rates are more favorable than the mortgage interest rate they are currently paying. The old rule of thumb regarding refinancing was that it tended it be a worthwhile financial endeavor if borrowers could reduce their current mortgage interest rate by about 2%.

Sage wisdom recommended that the interest rate drop by at least 2% because the closing costs–

• Increases the new loan amount, which will increase the monthly payment to reflect this mortgage amount increase. Or,
• Must come from the borrower’s pocket/savings, which must be reflected in the financial decision.

Reducing the mortgage interest rate will reduce monthly mortgage payment outlays; it will also accelerate the rate in which a borrower can build equity in their home. This interesting phenomenon is depicted in the table below –

Mortgage Amount	Monthly Mortgage Payment	Current Interest Rate	Principal Portion (1st Payment)	Interest Portion (1st Payment)
$100,000	$599.55	6%	$99.55	$500.00
$100,000	$477.42	4%	$144.09	$333.33

By refinancing from 6% to 4%, the borrower’s monthly payment decreased by $122.13 ($599.55 – $477.42 = $122.13), while, at the same time, the principal portion of the monthly mortgage payment increase by $44.54 ($144.09 – $99.55 = $44.54).

The reality is, a refinance such as this sets up a situation for a borrower where their money simply works harder. Note, however, the borrower must be comfortable with the larger monthly mortgage payment that is typical of a shorter-term mortgage.

Yet, the reality is, there are many instances where it makes financial sense to refinance when the rate is lowered by less than 2%. Consider the following –

• Example # 1 – it would make financial sense to refinance to lower the interest rate (to something less than the current rate), but also reduce the current loan term by 5+ years. Depending on the loan specifics, this could save a borrower thousands of dollars.
• Example #2 – it would make financial sense to refinance to a lower (or even the same rate) if the payment term is being extended (i.e., 15 years to 30 years). Extending the loan term will reduce the monthly payment.
• Example # 3 – it would make financial sense to refinance and pull out equity with no change in the payment amount.
• Example # 4 – it would make financial sense to refinance – independent of interest rates – when choosing to convert an Adjustable Rate Mortgage (ARM) to a fixed-rate mortgage. This type of refinancing is best for those borrowers who prefer to know their monthly payment will not be modified during the life of the loan.

Refinance Option #2 – Reducing the Loan Term

Most mortgages are issued at a traditional 30-year term. A 30-year term typically allows most working borrowers an opportunity to make homeownership affordable by spreading out the payments over 360 months. It is easiest to understand just how valuable this refinance option can be by reviewing the differences in overall mortgage payments for the same loan terms and only adjusting the term of the loan.

Current Mortgage – 30 Year Payout

Here are the relevant mortgage loan variables –

• Mortgage Loan Amount – $100,000.
• Interest Rate – 4% per year.
• Loan Term – 30 years.
• Mortgage Payment – $477.42 per month.
• Total of monthly payments over the life of the loan – $477.42 * 360 = $171,871.20.

Proposed Mortgage – 20 Year Payout

Here are the relevant mortgage loan variables –

• Mortgage Loan Amount – $100,000.
• Interest Rate – 4% per year.
• Loan Term – 20 years.
• Mortgage Payment – $605.98 per month.
• Total of monthly payments over the life of the loan – $605.98* 240 = $145,435.20.

Although the monthly payment for the mortgage would rise, the borrowers would save $25,436 Over Life Of The Loan.

Proposed Mortgage – 15 Year Payout

Here are the relevant mortgage loan variables –

• Mortgage Loan Amount – $100,000.
• Interest Rate – 4% per year.
• Loan Term – 15 years.
• Mortgage Payment – $739.69 per month.
• Total of monthly payments over the life of the loan – $739.69 * 180 = $133,144.20.

Although the monthly payment for the mortgage would rise, the borrowers would save $38,727 Over Life Of The Loan.

Refinance Option #3 – Converting from an ARM to a Fixed-Rate Mortgage

When mortgages were first introduced, lenders offered fixed-rate loans. Borrowers often prefer fixed-rate mortgages because the monthly payments offer certainty over the loan term.

From a business perspective, lenders are never pleased they had to lock in an interest rate (the bank’s investment) for 30 years – when interest rates change based on market and economic conditions as often as daily or even hourly.

In response, the lending sector created the Adjustable Rate Mortgage (ARM), which became a popular lending product because –

• ARM interest rates often begin with an introductory rate that can change at preset intervals based on preset factors. The lower intro rate – although temporary – was quite appealing to borrowers, at least at first.
• Lenders could adjust their return on investment (the interest rate) periodically, as market and economic conditions dictate. In other words, the lender’s capital would be lent at an interest rate that would reflect more current market conditions.

Adjustable-Rate Mortgages were a smart financial tool for several reasons, but not always the right mortgage for everyone. For instance, a new college grad – with assurances of a rising income – would benefit from an adjustable-rate mortgage.

Adjustable-Rate Mortgages adjust periodically, with each ARM offering different terms and conditions. At the pre-determined change date(s), the interest rate will adjust based on an Index, plus a margin, which essentially acts as the bank’s profit line. The index is generally a market-wide acceptable index like –

• The Cost of Funds Index (COFI).
• 6-Month Treasury Bill (T-Bill).
• The One Year Treasury Bill (T-Bill).
• The Federal Home Loan Bank Board Rate (FHLBB).
• The London Interchange Bank Offer Rate (LIBOR).
• Prime Rate, to name just a few.

But the reality is about ¾ of residential mortgages funded are fixed-rate mortgage instruments. Most borrowers prefer a fixed-rate mortgage – be it a 10, 15, 20, 25- or 30- year term – because the certainty of the monthly payments for the mortgage allows them to create a working home budget easily.

Converting to a Fixed Rate Mortgage

It is noted that some of the more new-fangled ARM loan gadgets offer a conversion option during the loan term. However, it is important to determine how the mortgage product calculates the fixed rate should a borrower pull the trigger on this conversion option. It is likely the bank will have built in some profit/incentive to allow the borrower to convert to a fixed rate.

Not all ARMs offer conversion options. For those borrowers who wish to switch to a fixed-rate mortgage should just reach out to a quality lender/mortgage broker and simply apply for a fixed-rate mortgage.

Refinance Option #4 – Tapping into the Home Equity

Over the past century, real estate has consistently offered a solid and consistent investment for one’s family finances and one’s financial retirement goals. Over the more recent past, homeowners have used their home’s equity to help –

• To pay off or consolidate high-interest debt. Mortgage rates are usually significantly lower than credit card interests. This is true for many reasons, but primarily because a mortgage loan is secured debt and somewhat managed by federal oversight agencies.  However, a mortgage also finances the American Dream.

Credit card debt is unsecured debt and considered a significantly riskier investment from the bank’s perspective. The elevated nature of the risk is one of the fundamental reasons that credit card interest rates are so high.

The key here to consolidate the high-interest debt to one lower payment (often with deductible interest payments) but NOT to re-run the credit card debt up.

• To obtain funds for emergency purposes. Many borrowers choose to maintain a HELOC – a Home Equity Line of Credit – that allows immediate access to funds in emergencies by simply writing a check off the existing line of credit.

Borrowers can also refinance to pull out money for emergencies by simply refinancing. Still, mortgage processing typically takes about two months to close a mortgage loan – assuming there are no hitches or glitches along the way.

• To obtain capital for home improvements or an addition. Equity accumulated is often used to upgrade a home with more energy-efficient appliances, or to add an addition to a backyard pool.
• To obtain capital to pay for college, etc. Many parents choose to access the equity in their home to help fund their children’s educations.
• To obtain capital to open a business. Many businesses have begun with the use of equity pulled from a borrower’s primary residence. Borrowers are advised to seek business advice from a lending expert and business consultant when considering pulling equity from a home to a business venture.

The Takeaway

Refinancing is a personal decision and highly dependent upon the borrower’s current situation, market conditions, and the borrower’s financial goals and objectives. With interest rates at or near historic levels, many borrowers would benefit greatly from running the numbers and discovering the potential savings available with the unheard lending conditions during the first half of 2020.

What have you got to lose?