Time to Refinance?

Recently, the average rate on 30-year mortgages hit its lowest level ever. Could refinancing be right for you? The answer comes down to the tradeoff between 1) the lower interest rate and monthly payments with a new mortgage and 2) the costs (and time and hassle) involved in getting it. As a general rule of thumb, experts say that a refinance may be worthwhile if it will net a homeowner an interest rate between 50 and 75 basis points lower than their current mortgage’s rate. Rates on 30-year fixed mortgages were 50 basis points higher as recently as March, so that means that just about anyone with a pre-Covid-19 mortgage may want to consider refinancing.

Why Are Mortgage Rates So Low?

Interest rates are low because economic policymakers want them low in order to encourage an economic rebound from the onset of the Covid-19 pandemic and the government lockdown of the economy. In particular, the Federal Reserve, which historically limited its activities to the short end of the Treasury yield curve, has redoubled its “quantitative easing” activities first initiated after the Great Recession, buying not only Treasuries, but also mortgage-backed and even corporate bonds, and in the wake of Covid-19 has spread its bond buying farther out the yield curve than ever before.

The result, as shown in the graph below, is that the average 30-year fixed-rate mortgage recently hit a new low.

Will Rates Go Lower?

Mortgage rates are generally related to the rates on Treasury bonds of the same maturity. The 30-year Treasury yield hit a recent low of 1.20% on August 6, and has drifted a bit higher since then, as shown in the graph below. It appears that long-term interest rates may have found a bottom. Interest rates below 2% are likely to be negative in real terms since the Fed’s inflation target is 2%. In fact, the Fed has recently been floating the idea of using 2% as a average rather than as a target maximum, so they appear to be more willing to let inflation rise above 2%, at least for a while.

Commensurate with the Covid-19 pandemic and government shutdown of the economy, Treasury bond yields plummeted. Ever since, yields have been keenly influenced by perceptions regarding the pace of economic recovery. Interest rates now tend to increase in response to news that the economy is stronger than expected, or that rates of infection are declining more than expected, or that a vaccine may become available sooner than expected. Rates decline on news indicating the opposite. Further complicating things is the fact that the Federal Reserve may step in, with either monetary easing talk or action (it really doesn’t much matter), if the economy appears to be weakening. That can drive down rates more than anything. However, the Fed has already done quite a lot to drive down rates. From here the greater likelihood is that signs of economic recovery will strengthen, driving up interest rates, and the Fed will see this as an indication of success with no further need of extraordinary monetary stimulus.

Whether rate go up or down a bit from here is unknowable. What is obvious is that rates are extremely low relative to history. There is a good chance that mortgage rates may never again be this low in our lifetimes. If ever there was a good time to consider refinancing your mortgage, this is it.

How Do I Calculate My Payback Period?

It is important to consider the costs of a mortgage refinancing when deciding whether it is a smart financial move. Add together all closing costs, including such items as processing fee, appraisal fee, credit report fee, tax service fee, settlement fee, and title insurance. (That last one is usually the biggest, at least here in PA.) Typically closing costs will run into the thousands of dollars. Your lender will be able to supply you with a list of estimated closing costs. You will also need to know the amount of your current monthly mortgage payment and the new payment at the new (lower) interest rate. The “payback period” is the length of time required to recoup the initial cost of the refi:

Total closing costs / (Old payment – new payment) = Payback period

For example, according to the American Land Title Association, the average closing cost paid in 2018 in Pennsylvania was $4,050 (excluding taxes) on a sales price of $201,151. That was 2.01% of the sales price. (Unfortunately, PA has the highest closing costs in the U.S. Title insurance in PA is set by the state and is very expensive. No doubt title insurance companies have excellent lobbyists.) If the average PA resident can save $100 per month by refinancing, using the average closing cost of $4,050, the payback period would be 40.5 months or about 3 1/3 years, using the formula:

$4,050 / $100 = 40.5

You will want to assess the probability that you may move away before the payback period. Research published by The National Associate of Realtors indicates that as of 2018, the median duration of home ownership in the U.S. was 13 years, up from 10 years as of 2008. However, the length of home ownership varies by region and area. Fast-growing areas have shorter median durations. For example, median home ownership is only 7-8 years in sunbelt cities such as Austin, TX, Cape Coral, FL, Las Vegas, NV, and Phoenix, AZ. In contrast, the Northeast tends to have the longest median duration. The median is 16 years in Pittsburgh, PA, Buffalo, NY, and Springfield, MA.

Of course, your situation is unique and your expected length of stay in your home will be influence by many factors unique to you. The shorter the payback period, the more compelling the case for refinancing.

What About the Tax Implications?

Not to put too fine a point on it, but you should also consider the fact that closing costs are not immediately tax deductible (they can be spread over the life of the mortgage), but mortgage interest is if you are itemizing. Since the standard deduction was doubled under the new tax law, far fewer taxpayers are itemizing, but those with higher incomes often are. For 2020, the standard deduction for taxpayers who are married filing jointly (MFJ) is $24,800. For single and separate filers, it is half of that, or $12,400. Unless your mortgage interest, charitable contributions, state and local taxes, and other deductible expenses are above the standard deduction, you are better off not itemizing. Itemizers should “tax-adjust” the difference between their old payment and their new one in calculating their payback period:

(Old payment – new payment) X (1 – marginal tax rate) = Tax-adjusted payment difference

There are limits to the deductibility of mortgage interest. Under the post-2017 tax law, taxpayers who are married filing jointly (MFJ) can deduct home mortgage interest only on the first $750,000 ($375,000 for single or separate filers). However, higher limitations ($1 million for MFJ or $500,000 for single filers) apply if you are deducting mortgage interest from indebtedness incurred before December 16, 2017. So if you have one of these “grandfathered” mortgages, you may not want to refinance and lose the extra deductibility. At a minimum, it should be considered carefully.

Isn’t Debt Bad?

I urge clients to think of the financing of their home as a financial decision rather than emotional one. Granted, there is an emotional appeal to owning your home “free and clear” of any mortgage obligation. However, a mortgage is the least expensive loan most people will ever have, and it is made even cheaper for those who itemize by the tax deductibility of mortgage interest. Right now, 30-year fixed rate mortgages are available for only 3% interest. I believe it is quite reasonable to expect a well-diversified portfolio to earn a return that it noticeably above that. And taxpayers in the 32% bracket (for example) who itemize are effectively paying only a 2% after-tax rate of interest. Think about it. Would you rather invest in paying off your low-rate mortgage or invest in a diversified portfolio of stocks and bonds?

Not all debt is bad. When used to finance a long-term asset, especially if that asset is likely to appreciate, using debt to finance the asset is probably a smart thing to do. To be clear, I am not arguing that debt is only appropriate if the real estate value is likely to appreciate at a rate higher than the mortgage rate of interest. Presumably, the real estate was purchased as a desirable place to live (or vacation). Perhaps its investment value also figured in, but that should be only a secondary consideration in most cases. How you finance the real estate is a separate decision. Typically, real estate can be financed with anywhere from 100% equity to 20% equity and 80% debt. I am arguing that in general, 20% equity is optimal from a strictly financial point of view.

Which Mortgage Term is Best?

I am a big fan of the 30-year fixed rate mortgage, especially in this interest rate environment. Yes, there is some emotional appeal to paying off your mortgage sooner than 30 years from now, but most mortgages allow the borrower to prepay principal at will. That means that if you want to, you can still pay it down, but you are not forced to do that. You have flexibility. That is a good thing.

Besides, 30-year mortgages have lower monthly payments than 15-year mortgages. If what you want to do is maximize the amount that you are able to invest for the next 30 years, as I am arguing, then you want to keep your monthly payments as low as possible. This will maximize the positive spread over your mortgage interest rate that you will be able to earn on the money you invest, on average, over the long-term.

Even aside from that consideration, 30-year mortgages are cheaper than usual relative to 15-year mortgages right now, especially relative to most of the post-Great Recession time period, as shown in the graph below.

If, like me, you are convinced that long-term interest rates are more likely to go up than go down in the years ahead, you want to lock in the current low rate on as long-term a mortgage as you can get. Essentially, it’s like you are selling short the 30-year point on the Treasury yield curve. The more that rates go up from here, the better off you are for having locked in at this level.

How Much Can I Borrow?

It is helpful to have a good estimate of the value of your property. Since most lenders will not finance more than 80% of the appraised value, this will let you know your upper limit on mortgage loan amount. In addition to the well-known Zillow.com and Redfin.com you should also check the value on Homebot.com. All you have to do on these websites is put in your address and up pops their valuation estimate. Homebot pulls data from the local MLS (multiple listing service), public records and RealtyTrac, so compared to Zillow and Redfin, it may be somewhat more up-to-date and accurate.

The lowest mortgage rates are for those than can be easily sold in the secondary market to Fannie Mae and Freddie Mac. For 2020, the maximum conforming loan amount for most of the U.S. is $510,400. That means that an 80% LTV (loan-to-value) mortgage would max out at a home value of $638,000. For certain high-cost areas, that limit is bumped up by 50% to a maximum loan value of $765,600 ($957,000 home value at 80% LTV).

Of course, there are larger mortgage loans available (“jumbo mortgages”), but these are somewhat more expensive. Interest rates on jumbo mortgages used to be quite a bit higher, but in recent years the spread narrowed to almost zero. However, since the Covid-19 pandemic, the spread has widened out to about .25%. Also, underwriting standards tend to be stricter for jumbo mortgages.

Should I Take Cash Out?

There are two kinds of mortgage refinancings. The lower cost kind is a “rate and term” refinancing. In this case, the new loan amount is just enough to pay off your current mortgage balance (although it may also include closing costs). The new mortgage offers you a new rate (lower) and a new term (number of monthly payments).

The second kind is a “cash out” refinancing. In this case, the loan amount is a percentage of the appraised value of your home, typically up to a maximum of 80%. The cash left over after paying off your existing mortgage and closing costs is paid to you. Although the interest rate on a cash out refi is typically about .25% higher than for a rate and term refi in the current market, the implied cost on the added amount is likely to still be somewhat lower than other forms of financing, such as a second mortgage or HELOC (home equity line of credit).

Using a cash out refi to invest some of your home equity is a way of making your money work for you. As long as you invest in a reasonably conservative and well-diversified portfolio, it is likely that you will earn a positive return spread over and above the cost of financing on average over the long-term. Of course, there are no guarantees in investing, but based upon long-term past behavior, as long as your portfolio has a meaningful allocation to equities, your average return is likely to be above your mortgage interest rate over time.

My Own Recent Experience

I am currently in the process of refinancing my mortgage, and I have learned a few things. First, use a mortgage broker. A mortgage broker is essentially a middleman between the borrower and the lender. Although with many purchases you can save money by “cutting out the middleman,” at least in this case, I have not found that to be true. I have contacted a number of lenders directly, and I have found that in every case their rates were the same or higher than the rates I could get through a broker. Using a broker also saves the time you would otherwise have to spend contacting many lenders directly yourself.

Second, be prepared for stricter underwriting standards. The Covid-19 pandemic has all financial institutions worried about rising loan defaults. Not only have many people already lost their jobs, causing genuine hardship, but the government has encouraged people to stop paying their mortgages if they have been affected by the pandemic by suspending foreclosures through diktat. This has placed an incredible burden on mortgage lenders. They do not want to loan to anyone they think might stop paying, and the likelihood of that happening has never been higher.

Here again a mortgage broker can be helpful by steering you to a lender that is known to be accommodative to situations like yours. In my case, I started Sapient Investments just over two years ago, and I am building my business from a small base. My current income is not as high as I expect it to be in future years. Fortunately, I have savings that I can draw upon while I am building the business. Some lenders are more flexible towards self-employed borrowers than others. Mortgage brokers know their lenders based upon their experience with them.

My objective is to get an 80% LTV cash out refinancing so that I can invest the cash, as I am encouraging you to do in this article. I’d like to get as high an appraised value of my house as I can to maximize the loan amount. Here again, mortgage brokers know which lenders are likely to fit with my objective. In my area, there are different pools of appraisers, and the various pools have reputations for either being generous or stingy. Mortgage brokers know the appraisal pools and which lenders use which pool.

Mortgage brokers get paid either by the lender (the usual arrangement) or by the borrower. Their fee is typically 1% to 2% of the loan amount depending on the size of the loan, although for very large loans it may be below 1%. It seems easier to negotiate the fee under a borrower pays arrangement, so that is what I am doing. Lenders give mortgage brokers “wholesale” rates which they are able to mark up to “retail” and thereby collect a “yield-spread premium” from the lender—a kind of bonus for getting the borrower to accept an above-market rate. Be sure to keep thoroughly shopping rates until you lock to make sure that you are not paying a rate that is above market! Comparison shopping for both fees and rates is your best protection.

I contacted several mortgage brokers in my area before I settled on one. You can find them by typing “mortgage brokers near me” in Google, by using an online referral service, or by asking for referrals from friends, family, and realtors. I would recommend talking to at least three of them to get a sense of who is out there, what their fees are, what their experience is working with borrowers like you, which lenders they work with, etc.

Summary

Mortgage rates may never be this low again.
Compared to your current rate, the payback for refinancing may be fairly short.
Mortgage interest is tax-deductible if you are itemizing, making it even cheaper after-tax.
Your home may be worth more than you think—check a few online sources to get a rough estimate.
You may be able to do a “cash out” refi and invest some of your equity in a diversified portfolio with an expected return well above your mortgage interest rate.
A mortgage broker can be helpful in finding the right lender and the right loan for you.