There are plenty of incentives for refinancing right now, the question is, should you refinance your mortgage? Above all, we think that it’s important you know all the facts. Typical advisors will often caution you against refinancing because of longer loan terms and more interest…and we’d argue something is missing in that analysis.
Interest rates often drive these conversations, yet it’s important not to let them dictate your decision entirely. Whether it’s dropping interest rates, or interest accumulated over the term of your loan, you must consider the rest of the facts. So let’s dig into it: how has lending changed, is equity the key, and how important is interest?
How Lending Has Changed
Before pouncing on the low interest rates we’ve seen in the last few months, did you know that the number of refinances have actually decreased? It might surprise you to learn that along with low rates, banks have tightened their standards on who can lend, how much, and when.
If you think back to the housing situation of 2008, it makes more sense for lenders to protect themselves preemptively to avoid a foreclosure crisis. So what are the new standards? Lenders have tightened the requirements for credit score, down payments, and income requirements. The minimum credit score could be as much as 700.
Even government guaranteed loans such as FHA (Federal Housing Administration) loans are tightening up, though historically they’ve been easy to qualify for. While they’re more accessible than private loans, those with lower credit scores will likely have to drop a larger down payment to qualify. Rates might also be higher.
That means while you may have qualified for a loan in January, you’re could no longer able to secure one now. If you’re hoping to avoid unpleasant surprises, and protect your credit score from rejected applications, consider meeting with a mortgage professional before making any offers.
Is Now the Time for Home Equity?
We’re not so sure. Unless you’re in dire need, we suggest not to utilize a “cash-out refi” (where you borrow more than you currently owe). In fact some lenders are barring clients from pulling out cash in a refinance. Regardless, a refinance likely requires a minimum of 20% equity.
And what about a HELOC (Home Equity Line of Credit)? With many people at home in the past few months, opportunities like home improvements have increased. Accessing your equity is a common way to finance these projects, and can even be tax deductible. However, just as lenders are tightening requirements on regular loans, some have also frozen access to equity. (If you do have cash value life insurance, you can use a policy loan to finance such projects, and your access will never be restricted or questioned. Just make sure to leave a good chunk for emergencies).
Be wary, however, of using a HELOC as a way of paying off your mortgage “faster.” The only way to truly pay your mortgage off faster is to make larger payments. There’s no magic in a HELOC, only smoke and mirrors. Pay attention to the interest rates, and you’ll see.
What About Opportunity Cost?
When it comes to the length of your mortgage, don’t forget about opportunity cost: the cost of using your money for one opportunity over another. When you’re looking at payments, consider what a lower or higher payment will do for your lifestyle. Will a lower payment allow you more freedom to invest and save money? Choosing a 30-year mortgage not only lowers your monthly payment, it allows you to refinance in the future.
Typical financial advisors often push the narrative that you should refinance for shorter time periods to save on interest, yet we’re not convinced. Not only will a lower payment give you more monthly flexibility…it could provide huge opportunities.
Warren Buffet himself advocates for the 30-year mortgage, and you’ll be blown away when you learn how he leveraged his mortgage. In 1971, he bought his Laguna Beach home for $150,000 (about $900,000 in today’s dollars). Although he could have paid for the home in cash, he took out a mortgage of $120,000 anyway. And you know what he did with the money he would have used to pay in cash? He invested it back into his company, Berkshire Hathaway.
Buffet thought he could do better than his equity, and he was right—with the 3,000 or so shares of Berkshire that he bought, he earned back today’s equivalent of $750 million. And he recently put his home on the market for $11 million. By choosing to have a mortgage, Warren Buffet increased his revenue exponentially—he could buy 68 homes in Laguna Beach with that money. How can “saving interest” compare to that?
Get a CLUE About Mortgages
When it comes to mortgages, remember to have a CLUE. It’s a handy acronym to remember any time you’re making a big financial decision.
CONTROL: A lower payment gives you more options, and therefore more control. You’ll have greater cash flow, which enables you to pay down credit cards, as well as save and invest money.
You cannot control the appreciation or depreciation of your home equity—in fact, the closer you are to paying down your mortgage, the more control the bank or lender has. You can only control the dollars in your own hand.
LIQUIDITY: If your money is not liquid, do you really have control? By accelerating your mortgage, you’re essentially storing dollars in the walls of your home. When opportunity (or emergency) strikes, you’ll be unable to access that money.
Homeowners who are currently unemployed and need cash are being turned denied lines of credit from their own equity. Especially when they have no verifiable income apart from unemployment checks. Think about that.
Equity in your home is not equity you control. Store your money where it is accessible whenever and however you want.
USE: When discussing the pros and cons of buying vs. investing, many people often forget that a home isn’t just an investment—you can use it too! This is another advantage to the 30-year mortgage: guaranteed low payments increase the flexibility you have when it comes to using your home.
What if, for instance, you were interested in moving? You could keep your old home and rent it out, which is a viable long-term solution if your mortgage is low. Otherwise, it’s riskier to charge a fair price and still have some cash flow.
EQUITY: As a homeowner, you’ll build equity over time through a combination of appreciation and paying down your mortgage. And while this is a wonderful thing, putting too much emphasis on building equity can back you into a corner (as we’ve mentioned above). Since you’ll naturally build equity by making payments, it’s important to focus on building wealth outside of your home as well.
As our Warren Buffet example demonstrates, while some are hyper-focused on paying off their mortgage debt quicker, the wealthy are:
- Increasing control over their wealth
- Maximizing their cash flow
- And expanding their assets
You can do this, without needing to be a millionaire, by starting small. An asset that we recommend is high cash value life insurance, which increases your control and liquidity. And depending on how you use it, you can also leverage it into cash flowing investments. This is on top of the other benefits of insurance.
So, Should You Refinance Your Mortgage?
We hope that with the information above, you’ll be able to take the right steps. Be aware of the increased difficulty in securing loans, and ensure that you’re doing it for the right reasons—CLUE. And hopefully, we’ve inspired you to think outside the box when it comes to debt associated with homeownership.
Busting the Interest Rate Lies
For a better understanding of interest rates (and the things many people don’t know), check out the book, Busting the Interest Rate Lies. The book expands on opportunity cost, as well as the role of interest rates in mortgages and other big purchases.
If you’d like to speak with a Prosperity Economics Advisor about the concepts above, and how to implement them, contact us today.