In Financial Advisor, Wealth Management

Does it sometimes seem that everywhere you look, friends or family members are talking about buying a new house or refinancing their existing mortgages? Perhaps you are considering whether or not to refinance your home mortgage.

If so, you are not alone. Guidance from a financial advisor can help you know if refinancing your mortgage makes sense for your long-term goals.

Why are rates so low?

The Federal government can help manage the economy by using monetary economic policy, which affects interest rates. In response to the economic crisis caused by the global pandemic, the Federal Reserve has injected “liquidity” into the system using major public policy levers that it controls. In theory, lower interest rates encourage spending (as it becomes more affordable to borrow money), which in turn helps boost the economy.

The Federal Reserve has been using two major policy levers most recently:

  • Fed Funds Rate Target: The fed funds rate is the interest rate that banks charge each other to lend Federal Reserve funds overnight. This interest rate is a benchmark that banks use to price other financial services, such as interest rates on credit cards, mortgages, and bank loans. Therefore, when the Federal Reserve lowers its target, it has a massive ripple effect on borrowing costs throughout the economy. About a year ago, the target fed funds rate was 2.00% (9/14/2019), whereas now it is 0.00-0.25%.  This makes it much less expensive to borrow capital.
  • Open Market Operations: The other area where the Federal Reserve has the most ability to affect interest rates is through buying securities in the open market. Before the pandemic, the Federal Reserve had $4.1 trillion in assets on its balance sheet. As of August 2020, that figure stood at $7.0 trillion. This recent $3 trillion increase was more than all purchases combined during the Great Recession 2009-2012.

Federal Reserve Balance Sheet – July 30th, 2007 – September 16th, 2020

federal reserve balance sheet

Current monetary policy has significantly affected the benchmark mortgage borrowing rates, lowering all three major rates below 3.0% for the first time in recent history. To put this in perspective, interest rates have fallen nearly 40% from where they were in November 2018.

Freddie Mac – Primary Mortgage Market Survey

primary mortgage market survey

Source: Freddie Mac

How have borrowers responded?

Credit-worthy borrowers looking to finance or refinance real estate holdings have responded in spades.

Since this spring, mortgage loan application volumes have surged as people have flocked to take advantage of this historically low interest rate environment. And each decline in rates seems to spur yet another rebound of refinancing activity – in this environment, mortgage refinancing has emerged as a particularly popular topic.

To follow what is going on, people commonly look at data generated by the Mortgage Bankers Association’s (MBS) Weekly Mortgage Applications Survey.   While the numbers have bounced around a bit this year, for the week ending September 4th, 2020 new purchases of homes were +40% from the same week last year, and the refinance loan application index volume was +60% higher.

In terms of refinancing activity, according to this survey the refinance share of mortgage activity increased to 63% of total applications for the week ending September 4th, 2020.

So, does refinancing make sense for me?

Well, it depends on a variety of factors and each person’s situation is unique. This is where working with a financial advisor can help you make a well-educated decision.

Securing a lower interest rate on your existing loan.

All things being the same, a lower interest rate is almost always in your best interest.  Lower interest rates can reduce your monthly payment, increase the rate you build equity in your home, and help you save money over the life of your loan.

However, things are often not the same.  For instance, you have fees associated with the transaction (appraisal, points).  Facts may have changed regarding employment (a spouse may be unemployed) or status (you could be renting your home while working abroad).  All these factors may make underwriting more difficult.

Don’t forget, when you refinance an existing 30-year loan into another 30-year loan, you are likely changing the maturity date.  For instance, while you may have a 30-year loan right now, if you closed the existing loan 10-years ago the loan will be fully paid off in 20-year years (its maturity date).  Re-writing your existing 30-year loan into another 30-year loan effectively pushes back your last payment by 10-years!

Is the refi interest rate sufficiently lower to justify the process?

This all depends.  For instance, if you have a 3.875% mortgage and your new rate would be 2.875%, that is a reduction of 1.00% in interest rate and a decrease of 26% (!) in interest expense.  However, if you are on schedule to pay off your mortgage in a few years, going through the effort may not be worth the hassle & expense.

Is refinancing with a cash out option of an existing loan a good idea?

Paying off your mortgage is a monumental financial achievement that you do not want to postpone too far into the future.  Refinancing your home and taking cash out is likely going to increase the time it takes to pay back your home mortgage loan.  For many, this can be tempting, but it is not necessarily sound financial planning.  Often this will significantly increase the time which you will be making payments, potentially stretching these mortgage payments into retirement.  Alternatively, if you use this additional capital to pay down higher-cost credit card debt it may make sound financial sense (as long as you don’t run up the credit card balances in the future).

Should I change the interest structure of the loan?

Sometimes changing from an adjustable-rate mortgage (ARM) to a fixed-rate mortgage or vice versa makes sense.

  • ARM to fixed-rate mortgage: this may make sense if current rates on a fixed-rate mortgage are lower than what you are currently paying on your ARM mortgage – – lock in lower rates and remove concern over future rate hikes!
  • Fixed-rate mortgage to ARM: this can make sense for people who don’t plan to be in their homes for more than a few years. Adjustable-rate mortgages are often “fixed” for shorter periods of time (5-7 years), but often have the advantage of lower initial interest rates compared with15- or 30-year loans.  Therefore, this is a great option for someone who plans to be in their house for a more limited amount of time.  However, after the “fixed” rate period ends, the ARM interest rate resets and “adjusts” to what the prevailing interest rate is. So, you run the risk of higher interest rates if you do not move,  not a great strategy in a rising interest rate environment!

Should I change the term of the loan?

Switching from a 30-year loan to a 15-year or 5/1 ARM could make sense, depending on your long-term financial plan.  15-year and 5/1 ARMs tend to have lower interest rates than 30-year loans, which makes it easier to put more of your monthly payments to reduce the principal balance of the loan.  However, not everyone has the cash flow to take advantage of slightly lower interest rates.

What about fees?

Other things to consider when thinking about refinancing are the associated fees and costs (e.g. points, appraisal), which can be used to help to determine your breakeven point. You want to make sure these don’t eat too much into any potential savings, especially if you aren’t sure you will be in the house for more than a few years.

Next steps

Thinking about refinancing your home, but aren’t quite sure if it is the right next financial step for you? Submit the form below to download our worksheet designed to help you start thinking about the process.


 

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