Is It a Good Time to Refinance Your Home?
In response to the falling mortgage interest rates, many Americans are refinancing their homes. Refinance applications were up a stunning 401.5 percent in March since the previous year, reported the Mortgage Bankers Association.
For many people, financing a home now will be a smart move! Rates are now at all-times lows. And while you won’t be earning as much in your savings account, it’s an excellent time to lower your monthly expenses with strategic borrowing.
How low are mortgage rates? 30-year mortgage rates hit an all-time low last week of 3.15 percent. That’s the average interest rate for a fixed-rate, 30-year mortgage. For context, the historical average is 7.96 percent! One year ago, a 30-year mortgage averaged 3.99 percent, according to Freddie Mac. (There’s a nice interactive chart at ycharts.com, screen shot below.)
As you contemplate a refinance, there are some things to consider. Be aware that there have been some changes in the lending industry that may impact you. Also, we encourage you to resist the temptation to either get a 15-year mortgage or do a “cash out” mortgage. We’ll demonstrate why as we look at refinancing from a Prosperity Economics perspective. While a 15-year mortgage may reduce the amount of mortgage interest you pay—there is a huge opportunity cost!
What to know about mortgage lending now.
In spite of record-low rates, refinances have plummeted in the last two months. That’s because lending standards have tightened dramatically. With the 2008 mortgage meltdown fresh in memory, lenders are taking measures to protect themselves from another foreclosure crisis. Credit score, down payment, and income requirements have tightened. According to Bloomberg, JP Morgan Chase now requires a minimum credit score of 700 for a refinance.
Government guaranteed loans such as FHA loans (from the Federal Housing Administration) have traditionally been easier to qualify for. They still are—but standards are increasing there, as well. Those with “fair” credit scores may have to either plunk down a larger down payment (10% versus 3.5%) and the rates may be higher, as well.
Some people that would have qualified for a mortgage in January may find they do not qualify now. You can avoid unpleasant surprises by meeting with a mortgage professional before you make any offers or decisions, and keeping them updated if your situation changes.
Is it a good time to tap home equity?
Unless you are in dire need of money due to the recent economic disruption, we would encourage you NOT to do a “cash-out refi.” (That’s a refinance in which you borrow more money than you currently owe.) And some major lenders, such as Wells Fargo, are no longer allowing borrowers to pull cash out in a refinance. And you will likely need a minimum of 20% equity in your home to do any refinance.
Another way that homeowners access equity is through a HELOC, or home equity line of credit. Since many people have been home with more time on their hands, there has been a rise in home improvement projects lately. A HELOC can be a suitable way to finance home improvements and when used for such a purpose, the interest can be tax deductible.
However, in the same way that banks are tightening lending standards, some are also no longer allowing homeowners to access their equity. Due to our extraordinary economic conditions, banks such as Wells Fargo, Chase, and JP Morgan have halted new applications for HELOCs. (If you have life insurance cash value, that is also good way to finance improvements. Just make sure you keep a healthy emergency fund!)
If you have a home worth $500k with a mortgage that was $400k and is now $350k, the best move is to simply lower your interest rate and payment by refinancing at the $350k level.
What type of mortgage is best?
A boring, traditional, 30-year conventional mortgage with a fixed rate is the most popular and, in most situations, the best type of mortgage! There are also situations in which an FHA mortgage or VA mortgage, for veterans, may make more sense (or be the only option).
Warren Buffett has also recommended the 30-year mortgage in the past. “If you find a house you like and you’re going to stay in the locale for a while, buy it with a 30-year mortgage,” Buffett told CNBC in 2017. As he explained, the homeowner’s ability to refinance to a lower interest rate in the future makes it even better.
“If you’re wrong and rates go to 2%, which I don’t think they will, you pay it off,” he said, meaning that higher interest mortgages can be replaced with new lower-interest mortgages if rates fall. “It’s a one-way renegotiation. It is an incredibly attractive instrument for the homeowner and you’ve got a one-way bet.”
Counting the Opportunity Cost
There’s another reason why Warren Buffett likes 30-year mortgages, and that is opportunity cost. When you borrow money at an incredibly low rate, extended over 30 years, it gives you more money to invest. (We discuss the idea of opportunity cost as it relates to mortgages in the Busting the Interest Rate Lies book, which we highly recommend.)
Recently, Buffett put a Laguna Beach home he bought for $150,000 in 1971 on the market for $11 million. The $150,000 price tag was pretty steep in 1971—it would translate to about $900,000 in today’s dollars—and Buffet took out a mortgage to buy it. As he explained in a CNBC interview, he took out a mortgage for about $120,000 to buy the home. Instead of buying the home with cash, he spent the $120,000 on Berkshire Hathaway stock (his company).
As Buffett explained, if he got his $11 million list price, he would make nearly seventy times what he spent for the Laguna Beach house. But his decision to get a mortgage and use his cash differently paid off even bigger. ”I thought I could probably do better with the money than have it be an all equity purchase of the house. I might have bought 3,000 shares of Berkshire or something like that… so that’s [worth] $750 million [today].”
If you’re doing the math… Warren earned the equivalent of 68 homes in Laguna Beach by investing the money instead! Yes, he could have “saved” some mortgage interest by paying cash for the house. But the opportunity cost of doing that would have eventually added up to hundreds of millions of dollars!
There are two other types of non-conventional mortgages worth mentioning. First, there has been a trend lately for people to refinance their entire mortgage with a HELOC. We strongly advise against this. In spite of special reports and videos that try to convince you that you’ll magically pay off your home faster with the same amount of money, it is smoke and mirrors.
Pay attention to the INTEREST RATE of these HELOCs and you will see that this is true. Don’t be fooled… this strategy is not in your best interest!
Second, if you are a senior with substantial home equity, you may qualify for a reverse mortgage. If you are in your mid-seventies or beyond and are in need of more income, this move might be worth considering.
A reverse mortgage eliminates a senior’s mortgage payment and can turn home equity into a lump sum or an income stream. Other options such as single payment immediate annuities for income can be helpful for income, as well. (Contact Partners for Prosperity to see how much an annuity might pay or if you need a reference for a reputable lender that does reverse mortgages.)
Getting a C.L.U.E. about Mortgages!
We often use the CLUE acronym to discuss whole life insurance. The same acronym can be used to explain the advantages of using a 30-year mortgage to finance or refinance a home.
CONTROL: A lower payment gives you more control over your cash flow versus a 15-year mortgage or prepaying a mortgage with extra principle payments. With fewer dollars going towards a 30-year mortgage payment, the additional cash flow can then be used to pay off credit cards or save and invest elsewhere.
A homeowner does NOT control the appreciation or depreciation of home equity. You can only control the dollars in your hand—not those you have given to the lender!
LIQUIDITY: When you accelerate paying off your mortgage, you are actually storing money in the walls of your home. Unfortunately, when emergencies or opportunities strike, you don’t have access to those dollars!
Home owners who may have lost jobs and need cash right now are being turned down for home equity lines of credit—especially if they have no verifiable income other than unemployment benefits. Let that sink in.
“You can’t eat equity,” says my friend (and co-author of Busting the Real Estate Investing Lies). He is correct! That’s why you want to focus on building and saving liquidity you control.
USE: An important point sometimes neglected in “buy vs. rent” discussions is this: your home isn’t “just” an investment. You get to USE it! And if you don’t own a home, you’re likely paying rent elsewhere. Over many years, that really adds up!
This is another reason we prefer a 30-year fixed mortgage. It gives you guaranteed low payments which might allow you more flexibility with the use of your home!
For instance, you might move to a new home and rent out your first home. This is a smart long-term strategy, but you’ll be less likely to do it if your mortgage payments are higher. Increased costs would mean increased risk and less cash flow for you.
EQUITY: Over time, a home builds equity, usually through a combination of appreciation and the paying off of a mortgage. This is, of course, a wonderful thing! You just want to make certain you don’t put too much focus on building equity you cannot access. You want to focus on building wealth outside of your home!
In this environment, you can increase your protection and control by freeing up cash to put into a whole life policy. Instead of prepaying a mortgage or getting a 15-year mortgage, it’s smarter to save in a vehicle like whole life insurance. In this way, you are building up dollars you can use for emergencies—or lucrative opportunities! You are also building valuable protection for the storms of life.
As Warren Buffett demonstrates, while the middle class tries to figure out how to pay off their mortgage debt faster, the wealthy work to:
- increase control of their wealth
- maximize cash flow
- and expand their asset base!
Busting the Interest Rate Lies!
For further information on understanding mortgages and opportunity cost, we suggest our book, Busting the Interest Rate Lies (Kim Butler and Mona Kuljurgis). This book follows the story of a man from high school throughout most of his life. Along the way, he discovers basic financial truths rarely discussed in personal finance about buying a car, purchasing a home, saving and investing.
We also invite you to download this PDF chart that compares a 15-year or “extra principle payments” mortgage with a 30-year “Prosperity Economics” mortgage strategy.
—by Kim Butler and Kate Phillips