The beauty of an economic downturn is cheap credit. Things are looking shaky in 2016 as investors flee to bonds, thereby pushing down interest rates.
Refinancing can be a daunting process, but it shouldn’t be with the right representative and proper frame of mind.
I recently refinanced one of my rental properties in 2015 and now is a good time to share with you some key things to think about and assess. Hopefully by the end of this article you will be able to make an informed decision and save lots of money as a result!
Knowing when to refinance is like being a bond trader. Bond traders obsess over inflation assumptions, and you should have at least a basic assumption as well. Clearly, there has been tremendous monetary expansion recently, which should ultimately lead to higher inflation. Basic economic theory says that for every new $1 dollar bill printed, there will be a $1 increase in prices in the overall basket of goods eventually. The key word is eventually, which could be decades away.
People have been waiting for higher inflation, and therefore higher rates for the past decade. Ironically, those with short-term fixed mortgages (ARMs) are this century’s winners, because rates are resetting at equal to lower levels than when they were originally fixed!
Inflation has been coming down now for over 25 years, and I see little reason to expect inflation to suddenly jump higher given the tremendous output gap in the economy. If inflation does start rising, at least you know that your assets are by definition also rising in nominal value.
The figure to watch is the 10-year US treasury yield. Currently at
3.4% 2% 2.7% 1.85% 2.2% as of 1H2016, the yield is hovering close to all-time lows. Meanwhile spreads between treasury yields and bank mortgage rates have narrowed since the crisis. Most long term duration mortgages are related to the 10-yr bond yield, hence whenever you see the stock market crashing,watch bond prices rise, and yields fall. This is the exact time to call your mortgage broker.
Now that you have made an assumption on inflation, you should consider matching your fixed rate duration with the time you plan to hold or pay off the loan. For example, if you plan to hold onto your property forever, but need as long a time to pay off the mortgage as possible, it behooves you to take out a 30-year fixed mortgage. Your base case scenario is that in 30 years, you will pay off your mortgage in full, but I suggest you pay extra when you can to save on long term interest costs.
On the other hand, if you plan to only keep your property for 5 years, or plan to pay off the mortgage in 5 years, it makes more sense to take out a 5/1 ARM (adjustable rate mortgage), especially if you think inflation stays benign.
Given the yield curve is upward sloping, longer duration loans have higher interest rates. This is a tautology for the most part, except during times of extreme economic duress, where the yield curve flattens, or inverts given people want their money as liquid as possible. Assuming a normal upward sloping yield curve, you will pay a higher rate for a longer duration mortgage.
Current 30-yr conforming mortgage rates are roughly
4.75%-5.25% 4.25%, 3.875% 3.5% while 5/1 ARMs (5 years fixed and floating thereafter) are at 4-4.25% 3.125% 2.25% as 1Q2016. This is why I encourage all of you to check for the latest mortgage quote on your property for free if you have not done so in the best 6 months. Rates have continued to go lower and you will save a lot of money!
The are a bunch of costs that go into refinancing which unfortunately eat into the savings of refinancing. The way to think about costs is to get the total cost of refinancing divided by the monthly savings of refinancing to see how many months it takes to break even.
For example, let’s say it costs $3,000 to refinance a $400,000 loan from 5.25% to 4.25%. Your monthly payment goes from $2,375 down to $2,135 for a savings of $240. Take the $3,000 in refinancing costs divided by $240 = 12.5. In other words, it takes 12.5 months for you to start benefiting from a refinance.
If you plan to take 360 months (30 yr fixed) to pay off your mortgage, your actually savings would be $83,400 (347 months X $240) making the $3,000 cost to refinance a no-brainer. Ironically, you save less if you pay off your loan quicker from a refinancing stand point.
You should also ask your broker what the cost would be to refinance at a higher rate. In this example, you could get a “credit” to your costs if you refinanced for 4.75% instead of 4.25%, thereby having less money leave your pocket. The general rule of thumb is that if you plan to stay in your house for over 5 years, and it costs no more than 20 months until you break even, you should refinance.
30-YEAR FIXED vs. ADJUSTABLE RATE MORTGAGES
The benefit of a 30-year fixed loan is that you know what your payments are for 30 years. The payment will never change, only the mix between principal and interest. As a long term fixed loan, you pay up for the “privilege” of security.
With a 5 year ARM for example, you pay a lower interest amount in exchange for not knowing what your mortgage rate will be in year 6. Good thing is that there is generally a 5% cap increase. The bad thing is, your payments could literally more than double going from a 4.25% interest rate in this example to 9.25%!
If you took out the 30-year fixed mortgage, in year six you will still be at 5.25%. Hence, having a strong belief where inflation and therefore interest rates are going is important.
People think that adjustable rate mortgages are dangerous and bad. It’s just not true. An ARM is a wonderful option to save you money by allowing you to pay a lower interest rate if you believe inflation is benign, and if you only plan to hold the property for a shorter number of years. ARMs generally come in 1, 3, 5, 7, and 10 year durations.
PITA FACTOR (Pain In The A** Factor)
It would be nice if one could just snap one’s fingers and change the terms of the loan. Unfortunately, it’s not that simple and you need to spend at least 5 hours of your time speaking to your mortgage representative and preparing and signing the paperwork. A good agent should be able to tell you all the necessary documents you need to get things going.
The process generally takes about a month given the bank needs to pay off the loan, send an appraiser to figure out the loan-to-value ratio, check your income and assets, go through the title company to get the proper documents, pull insurance records from the homeowner’s association, and get you to sign everything.
The less you make, and the less busy you are, the more you should look into refinancing! If on the other hand, you’re happy with your loan, don’t have a lot of time, and make a ton of money, your time is worth more than the headache you will go through to save $16,000 bucks in the example above.
PUTTING IT ALL TOGETHER
If your mortgage rate is currently above 5%, consider calling your local bank’s mortgage department and asking what their latest rates are at various durations. The phone call is free, and you will potentially save thousands over the years.
To recap: 1) ask for rates 1% lower than your existing mortgage rate, 2) match your fixed rate duration with the length you plan to pay off the loan and/or own the property, 3) Calculate the break even duration by adding up the cost of refinancing divided by the monthly savings, 4) Consider refinances the loan if the break even duration is below 20 months (lower the better) and you plan to hold the loan for longer than 5 years.
If anything is unclear, please feel free to ask! I’ve been involved in a dozen loans with various types of properties, and perhaps I’ll be involved with one more very soon.
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Updated for 2016 and beyond.