You may want to pay down extra principal to qualify for a mortgage refinance. When mortgage rates are low, paying down principal to qualify for a lower mortgage rate is a smart move. The return on your capital could actually be quite high.
Let me share with you an example of when paying down mortgage principal to qualify for a mortgage refinance made sense. The guaranteed return on paying down a mortgage is the interest rate. However, that’s not the end of the calculation.
Pay Down Extra Principal To Qualify For A Mortgage
A while ago, my 5/1 jumbo ARM refinance ran into a snafu. I was trying to refinance a 2.625% 5/1 ARM in its 5th year into another 5/1 ARM at 2.375%. If I let the ARM adjust after the 5th year, it would have adjusted to 3.375% or higher since the rate is based off LIBOR + a 2% margin.
The mortgage amount was $981,000 and I was paying $4,338 a month. Roughly $2,192 of the $4,338 monthly mortgage payment goes to principal.
If I were to successfully refinance to a 2.375% rate, my monthly payment would fall to $3,830 a month. $1,900 of the payment would go to principal. In other words, my cash flow would increase by $508 a month, but my monthly principal payment goes down by $292 a month.
I enjoy paying down principal every month because it’s like a forced savings account. My goal is to pay off the entire mortgage by age 50 (2027), or 22 years after I first took the sucker out.
Once a mortgage is paid off, there’s only one figure needed to calculate your net worth: the market value of the property. Just be aware there is a downside to paying off a mortgage early you might not realize. And that’s a loss of motivation to earn.
High Debt-To-Income Ratio Makes Refinancing Harder
Unfortunately, I wasn’t unable to proceed with my mortgage refinance due to a high debt-to-income ratio. Most banks have a debt-to-income ratio limit of 42%. With a $981,000 mortgage, I’m over that.
The irony is that if I were to successfully refinance the mortgage, my debt-to-income ratio would drop. This would make me more creditworthy because my income would go up by $508 a month.
With the combination of buying another property in 2014 and paying myself a modest salary from my online business, I just didn’t qualify for refinancing the full $981,000 amount. Instead, I only qualified for refinancing $800,000.
The solution is to pay down principal to qualify for a mortgage refinance. In this case, I would have to pay down a whopping $181,000 in principal.
Tough Decision To Pay Down Extra Principal
Paying down $181,000 worth of principal was a lot. At the time, I only had about $190,000 in liquid savings at the moment. But if I were to pay so much down, my monthly mortgage amount would drop to $3,160 from $4,338. This would be a $1,178/month cash flow improvement.
Given I wasn’t too bullish on stocks, real estate, or private equity over the next two years, I was thinking of paying down debt. Back then, I had normal investing cadence of $5,000 – $20,000 a month. Therefore, the chances of the $181,000 just sitting in my money market account for the rest of the year were high.
Finally, I had a 7-year CD coming due. I was also to receive my final tranche of deferred compensation as part of my severance package then as well.
If there is such a thing as being overly liquid, I’ll be entering that territory if I don’t pay down any extra principal this year.
Calculate The Return On Paying Down Extra Principal
The return I will receive on paying down extra principal in this case is the annual interest savings divided by the principal pay down amount.
For example, saving 2% on a $800,000 mortgage equals $16,000 a year in interest savings. $16,000 divided by the $181,000 principal pay down = 8.9%. A 8.9% return on $181,000 in principal pay down is a GREAT return.
Therefore, I decided to pay down extra principal to qualify for a mortgage refinance.
Things To Consider Before Paying Down Extra Principal
If you’re considering paying down extra principal to qualify for a mortgage refinance, here are eight things to think about before making a decision.
1) Liquidity situation.
Ask yourself how much money in the bank makes you feel financially secure. The answer is different for everybody. I like having six months of living expenses in the bank at a minimum. The rockier the times, the more I want.
When you pay down extra principal, you don’t lower your monthly mortgage payments. However, if you pay down principal to qualify for a lower mortgage rate refinance, then your monthly mortgage payments will be lower.
2) Upcoming purchases or expenses.
Do you want to buy another property? Will your car need replacing soon? Will you be having to pay outrageous private school tuition? How about upcoming medical expenses? If your monthly cash flow can’t take care of your expenses on its own, then paying down extra principal might not be a good idea.
3) Investment opportunity cost.
In a raging bull market, you want to have as much risk-asset exposure as comfortably possible. In the 7th year or later of a bull market, having a balanced portfolio of stocks, bonds, and risk-free assets is more prudent. I just can’t get too excited about anything right now. I Bonds are paying a huge rate.
4) Interest rate outlook.
There are two things involved with a successful mortgage refinance: 1) locking in an interest rate that makes sense, 2) passing the underwriting process. I was able to lock in a rate 0.125% off the all-time low I’ve seen for 5/1 jumbo ARMs.
I do believe interest rates will stay low for a long time. However, I just don’t know whether I’ll be able to time the bottom again. Here’s my argument for why you should get an ARM versus a 30-year fixed mortgage.
The long-term outlook for mortgage rates is down. However, there are times when inflation may be elevated, which results in higher mortgage rates. We saw that in 2022. But long-term, mortgage rates will likely resume their downward trend as inflation comes down.
5) Real estate outlook.
If you plan to own your property for the long term, it doesn’t matter whether the real estate market is increasing or declining. But if the length of ownership is less than forever, then you need to make an educated guess on the probability of a real estate meltdown occurring during the window when you plan to sell. If there’s greater than a 50% probability, you shouldn’t pay down extra principal. The reason is you may never get your money back.
Personally, I’m bullish on real estate long term. Mortgage rates will come down. Stock market money will flow into real estate, especially as more people realize how ephemeral stock market gains can be. Finally, a home is becoming much more valuable since we’re staying at home way more often.
As a result, I’m actively investing in private real estate funds. I want to invest in lower-valuation properties in the heartland for more passive rental income.
My favorite platform is Fundrise. They were founded in 2012 and now manage over $3 billion in assets and have over 380,000 investors investing in the heartland of America.
6) Income stability.
Do you have a recession-proof job? Or are you in a highly unstable and cyclical business? Everybody should refinance before losing their W2 income because you become dead to banks once you are unemployed.
At the same time, nobody should be tying up excess capital into their illiquid homes if their jobs is at risk. The more streams of income you have, the more income stability you have as a result.
During uncertain times, having strong passive income is more important. You can calculate your net worth all you want, but cash flow is more important.
7) Net worth composition.
Don’t put all your eggs in one basket as the saying goes. If real estate accounts for significantly more than 50% of your net worth, consider staying liquid or using your capital to invest elsewhere.
The 2008 – 2009 downturn punished a lot of homeowners because more than 80% of median homeowners’ net worth was in real estate. You can easily see a snapshot of your net worth composition if you aggregate your accounts with Personal Capital. It is a free financial tool I’ve been using since 2012 to help grow my net worth.
8) Return on principal pay down.
During the previous housing crisis, a lot of people had to do a “cash-in refinance” to pay down principal to get their loan-to-value ratio back down to 80% or lower in order to qualify for a refinance.
Back then, the interest rate spreads were significant e.g. a homeowner locked in a 6% 30-year fixed rate before the crisis, but could refinance to 4% if they got their LTV down. In my situation, I’m only talking about a 0.25% difference not a 2% difference.
Because my cash flow increases by $1,178 a month or $14,136 a year if I pay down my mortgage from $981,000 to $800,000, I could say that my return on $181,000 = 7.8% ($14,136 / $181,000).
Or, I can take my old annual interest payment ($981,000 X 2.625% = $26,000) – new annual interest payment ($800,000 X 2.375% = $19,000) / cash-in amount ($181,000) = 3.8% return. Or I can simply calculate the return based on the interest rate I am refinancing = 2.625%.
2.625%, 3.8%, and 7.8% returns all compare favorably to the current risk-free rate of return of ~1.75%. The question is whether you’re willing to take more risk to get an even greater return.
Always Do The Math Before Refinancing
Everybody should come up with a debt pay down plan. Once you have a plan, you’ll figure out ways to achieve your goal. My plan is to be done with this originally $1,220,000 mortgage by age 50. If I pay down an extra $181,000 in principal to qualify for my 2.375% rate, I’ll have 11 years left to pay off the remaining $800,000 balance.
I have zero regrets paying down an extra $200,000 in principal on a rental property in 2014 and 2015. It’s now mortgage-free and I couldn’t be more satisfied.
Some people have said it’s unwise to have so much capital locked up in one asset. That’s true if the asset accounts for a significant portion of your net worth. This rental property is less than 15% of my net worth, and will hopefully continue to decrease with an increase in the overall pie.
If you can, it’s worth paying down extra principal to qualify for a mortgage refinance. You won’t regret paying down debt and lowering your interest cost as well.
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