TO REFINANCE OR NOT TO REFINANCE

Many people have been unsure in recent months about what they should do with their residential mortgages; what impact rising interest rates will have on borrowers who took out adjustable rate mortgages in the last few years. Generally, it’s best to weigh this decision in light of your overall financial plan, but generically speaking, here is one way to evaluate your choices:

Although the Federal Reserve has raised rates 15 times in the last two years for a total increase of 3.75%, there has been surprisingly little movement in long-term mortgage rates (30-year-fixed and long-term ARMS defined as 5/1, 7/1, or 10/1). Current mortgage rates are only about 1% higher than their lows in July of 2003. The percentage of borrowers taking out ARMS has also not varied much, fluctuating over the last 15 years from a low of 12% to a high of 36%. This range has been consistent even in the last five years with our rates nearing the lows of the last 50 years! What this illustrates is that no matter what interest rates are doing, there is always a “right time and place” for an adjustable rate mortgage if the individual’s specific needs call for it.

This is not to say there isn’t a wonderful premium for the peace of mind a 15- or 30-year fixed mortgage (or a completely paid-off house) can provide. For many people, this is by far the right answer! However, for people who have not yet amassed adequate “working assets” (taxable investments, retirement accounts, rental real estate, etc.) to safely support their lifestyle needs indefinitely, they are dependent on utilizing mortgage debt as part of their estate structure.

For those who either (a) choose to maintain a mortgage for leverage and tax reasons, or (b) have no choice but to hold a mortgage for lifestyle reasons, there are decisions to be made. What is going to happen to people who took out 5- and 7-year ARMS in the last few years (fixed for the first 5 or 7 years, then adjustable thereafter) who will most likely be experiencing a rate increase in the upcoming years? Without proper planning, these borrowers will be hit with a significant increase in payments. Now is the time to plan for these changes. Each person’s situation will be different, but the first thing you need to do is to analyze the payment difference between your current payment on your ARM, and the increase in payment if you refinance to a 30-year fixed loan in today’s market.

For example:

A $600,000 loan taken out in 2003 on a 5/1 ARM at a 5% fully amortized rate is $3,220/month. If this loan is refinanced today into a 30-year fixed rate loan at 6.5%, the payment rises to $3,792/month, increasing the monthly cost by $572/month. Let’s assume this borrower has two years remaining on his 5/1 ARM. If he refinances, he will make extra payments of $13,728 ($572 x 24 months) plus approximately $3,000 in closing costs for an added cost of $16,728. For most clients in this circumstance, we recommend they keep the existing 5/1 ARM. Instead of trading in their low interest rate for a higher rate, they can be disciplined and pay themselves the added $572/month into a liquid side fund, as a reserve in case rates are much higher at the end of two years. The client can then draw on this $13,728 reserve to use to refinance at current market conditions and either pay down the mortgage to reduce the payment, pay points to buy down the rate, or draw a portion of the liquid side fund to offset a higher payment until rates come back down again.

A similar analysis can be done if you have a Negative Amortization loan. It’s important to note that interest rates are similar to the stock market – they go up and down pending market conditions. If rates are sky high at the end of the next two years, we would recommend a refinance to a short term ARM (monthly ARM, 3/1 or 5/1) as an interim loan until rates go back down (because they will at some point).

There are tools you can use to monitor mortgage rates if you’re interested. At Mission Wealth Management, we use a program called “Rate Watch” that monitors our clients’ loan rates daily, and looks for opportunities to refinance their mortgage if rates fall. The tool also “triggers” a review of options four months before an adjustment date on an adjustable rate loan. You can set up a similar “trigger” system at home.

Statistically speaking, mortgage planning today is very different than what it has been in the past. The average U.S. homeowner lives in their home for only seven years. And according to the Federal National Mortgage Association (Fannie Mae), the average American mortgage lasts just 4.2 years. People refinance for many reasons, including: restructuring their debt, improving interest rates, paying for a home remodel, or to cover current expenses. So as we look at our estates from a strategic, non-emotional perspective, refinancing decisions can be made to both take advantage of current trends and products and to improve financial lives today and tomorrow. The key is to integrate mortgage decisions into an overall financial plan so that, over time, you create the kind of lifestyle you would like to maintain going into your later years.