Yes You Should Refinance. But How?

With mortgage rates dropping like a brick, it’s becoming a no-brainer for us to refinance our home loan. Even though we just got a 30-year loan 2 years ago at 5.875%, we can get 30-year loans now for around 4.5% or lower. You might be in a similar situation.

Rule of Thumb

The rule of thumb I hear thrown around a lot is that if you can drop 1% off your mortgage rate, you should refinance. To get a more precise idea if refinancing is good for you, you should really take into account how long you expect to stay in your home and see if you break even on your refinance costs before then. A good tool for this is the Mortgage Refinance Breakeven calculator found here (thanks MyMoneyBlog).

Breakeven Point on Our Mortgage

I plugged our numbers into the tool:

  • $180k original loan
  • $235k appraisal
  • 5.875%
  • 28 of 30 years
  • income tax rate of 25%
  • $175k loan balance
  • 4.5% new rate
  • 30 years
  • 0 origination and points
  • $3000 in closing costs

The tool tells me that I’d break even on this refinance in 18-22 months. We’d save $177* per month on our payments, and so as long as we’ll be here for 2 years we’ll make up the refinance cost and then some. Since we are planning on staying here for at least 2 years, we should refinance.

* The spreadsheet says $147… must have used slightly different numbers.

Yes But

The only real questions now are (1) should we wait for rates to go lower and (2) what kind of loan should we get.

I’ll avoid (1) for now. I think there is a real chance rates go lower, but I don’t want to be too greedy. I want to take advantage of a good thing while we have the chance. So I’ll assume we can refinance at the current rates.

RE (2): if your home loan situation is anything like mine, you have a lot of options to consider when refinancing. In our case, we have a second mortgage for $30k which is interest only at a rate of prime plus 1% (I think about 4.25% right now). We also have more cash flow than we did 2 years ago and can afford a bigger payment if it means we’ll be paying off the mortgage sooner and saving money on interest rates.

So we have questions like:

  • Should we roll the second mortgage (M2) into the new mortgage to lock in this low rate?
  • Should we get a 20 year loan (at 4.25%) instead of a 30 year loan (at 4.5%)?
  • Should we keep the M2 loan as is and make principle payments toward it?
  • Should we refinance the M2 separately?

A Spreadsheet!

Calculating all of this can make your head explode. I created a spreadsheet that calculates just some of the factors, while leaving others out, and focuses on the most promising options for us. You can see it here: Coleman Family Refinance Options.

The main scenarios I focused on are:

  1. The status quo, i.e. keeping our current loans.
  2. Refinancing just our first mortgage (M1)
  3. Rolling our second mortgage (M2) into M1 (we’d pay PMI for 3.5 years since we’d have less than 80% equity)
  4. Refinance M1 for 20 years
  5. Roll M2 into M1 for 20 years (PMI for 3.5 years again)
  6. Refinance M1 and pay difference into M2
  7. Refinance M1 for 20 years and pay extra $2k/year into M2

The columns of the spreadsheet show:

  1. The scenario #
  2. A description
  3. Rate on M1
  4. M1 monthly payments
  5. M2 monthly payments
  6. PMI payment if applicable
  7. Total monthly payments
  8. Term of M1
  9. Annual Payment
  10. Total M1+M2 debt in 2 years
  11. Total M1+M2 debt in 4 years
  12. Total M1+M2 debt in 10 years
  13. Lifetime cost of loan (rough rough estimate)
  14. Notes

Note on the columns. Some of them are updated when you tweak the numbers, but the 2, 4, 10, lifetime columns were entered by me after running numbers in that break even calculator linked above.

The second table has the same columns as the first, but shows the difference in payments/debt/etc compared to the status quo. So it can tell us how much we’d save (or spend extra) on payments and how much more (or less) debt we’d have after 2, 4, and 10 years.

mortgage-options

There is also a table at the bottom of the spreadsheet showing expected returns if we made monthly investments at a 6% return. This is to help us calculate what we could be making with that extra $147/etc per month if we didn’t use it to pay off M2 or get a 20-year loan.

Some Pre-existing Notions I Had

Before I pull some numbers out and explain how we’re leaning, let me relay a few biases I had going into this.

1. I’m okay with our interest-only second mortgage. At 4.25%, that is a cheap price to borrow money right now. We’re making more than that on our money that we invest in our business and in our retirement accounts. Paying toward the principle on that loan would be like buying a 4.25% bond. Decent return, but not as good as we’re getting elsewhere. So I’m happy to loan at that amount indefinitely basically. However, I do think that rates will go up in the mid-long term. I don’t want to get caught with higher rates that are a strain to pay. Our idea has always been that we would use some kind of windfall (e.g. if we sell one of our website properties) to pay off that loan in one foul swoop. However, we should at least consider somehow locking in a rate for this.

2. I’m against paying PMI in theory. (That’s why we got a second mortgage before instead of one loan with PMI.) If you have the credit, other options are probably better for you. Some good info on PMI here.

Findings From the Spreadsheet

The key columns to focus on to compare options is the Annual Payments and the difference in debt in years 2, 4, and 10. The second table shows the difference in these numbers compared to the status quo. And so I can see that if I go with option #2 (refinance just the 1st mortgage), we’d save $1,764 per year and have $5,966 less debt/more equity after 10 years. If we held the loan the whole 30 years, we’d pay $21,985 less.

Now if I rolled M2 into M1 and payed PMI, we would still save $435 per year ($1,500 per year after 3.5 years) and have $12,538 more equity after 10 years since we’d in effect be paying principle on that M2 now. However, we would spend an extra $3725 or so on PMI those first 3 years, and sometimes it can be difficult to get PMI removed once you do have enough equity in the house. Overall though, it seems like using our savings from the refinancing to pay down M2 is a good use of our capital. It lowers our debt risk in the future.

You should be reminded here that not only do we have $5-12k more equity after 10 years, we could have invested the saved payments to have an extra $18-24k in our retirement accounts. Refinancing really is a good deal.

One option I really wanted to calculate was keeping our interest-only M2 and making principle payments to it instead of rolling it into the new mortgage or refinancing on its own. This would avoid PMI or additional refinance options. If we are disciplined, we can pay off M2 just as fast… but we’d also have some flexibility if we needed some monthly cash flow. Scenario #6 lays this out. We would end up paying as much per month/year as we do now. So no savings there, but we’re really okay with our current payments. We would however have an $31,336 less debt across both mortgages.

Scenarios #4, #5, and #7 basically come down to paying a little bit (or quite a bit) extra per month in exchange for less debt in the future and less interest payments over all. One nice thing about these plans is that 10 years out, we could have nearly $50k in equity built up in the loan. Combined with an appreciation in home value (I know, but we’re talking 10 years from now… let’s hope) we could have a nice size chunk to use as a down payment on a larger home.

Summary

I’ll let you know what we decide when we go through with things. I think I’m leaning toward refinancing just the first loan and making principle payments on our second mortgage/line of credit. Some things we need to think about:

  • Can we really get 6% on investments on money saved? 4.25-4.5% might be a good return for our extra cash in this market.
  • What is the risk that interest rates go much higher in the future, raising our minimum payment on M2?
  • What do we want our debt situation to be 2, 4, 10 years from now?
  • Can we really get the rates/fees I’m assuming here? 😮
  • Are deductions for interest payments, reductions in PMI or M2 payments, or other things I’m leaving out important?

I hope this helps people in a similar situation as me. And as always, I appreciate any feedback or advice you might have based on this. Cheers!

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Gold as a Commodity (via Crossing Wallstreet)

Great overview and background on Gold as a Commodity over at Crossing Wallstreet.

The summary for current investors is…

My view is that the Federal Reserve will raise interest rates earlier than expected. I don’t know exactly when that will be but it will put gold on a dangerous path. For now, my advice is to stay away from gold, either long or short.

… but you should read the whole thing for a lot of interesting tidbits on the history of gold and how to track and trade it. Here’s another quote from the article, but you should really read the whole damn thing.

Here’s a good rule of thumb. Gold goes up anytime real rates on short-term U.S. debt are below 2% (or are perceived to stay below 2%). It will fall if real rates rise above 2%. When rates are at 2%, then gold holds steady. That’s not a perfect relationship but I want to put it in an easy why for new investors to grap. This also helps explain why we’re in the odd situation today of seeing gold rise even though inflation is low. It’s not the inflation, it’s the low real rates that gold likes.

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