When is the right time to refinance my mortgage?

With the recent run of inflation and the Federal Reserve’s decision to increase the prime rate, one of the most frequent questions I hear from my clients is, “Is now a good time to refinance my mortgage?”

Or “what the heck is the prime rate, anyway?” The prime rate is the cost regional banks pay to borrow from the federal government. It impacts all lending costs because the banks will charge additional interest on borrowing costs.

While it is true that the cost of borrowing has increased over the last several months, it can still make sense to refinance. For most physicians, our most significant borrowing cost is our mortgage. Shaving even a ¼% off our mortgage can substantially impact interest payments over 15-30 years.

Take a Closer Look at your Mortgage Payment

Let’s back up and ask, what is a mortgage payment? Four components make up your payment for most traditional mortgage products – otherwise known as PITI.

  • Principal – this is the amount borrowed to purchase your house. Some borrowers add their closing fees to the principal to save cash on the front end.

  • Interest – the cost of borrowing money. The interest rate will vary based on the prime rate, your credit risk, and the loan length. But aren’t mortgages relatively safe for banks? Yes, banks can repossess the property if the mortgage goes into foreclosure.But there are other risks, including changes in interest rates. When interest rates drop, borrowers refinance and prepay the old mortgage. The bank loses out on many years of interest payments. Conversely, when interest rates rise, borrowers keep their old mortgage as long as possible
  • Taxes – Annual property taxes, paid monthly into an escrow account. As home prices rise and cities and towns re-assess property values, this leads to an increase in property taxes. Your mortgage company places these funds in escrow to pay your annual property taxes.

  • Insurance – Made up of homeowner’s insurance and private mortgage insurance (PMI), if required. Your annual homeowner’s policy is paid monthly into an escrow account like your tax bill. PMI is required when a borrower puts down less than 20% of the home’s cost. PMI is typically 1% of the loan value/year. For a $500,000 mortgage, PMI costs $5000 extra each year, or about $415 per month!

There are several reasons you may want to consider refinancing. You are in an adjustable-rate mortgage and would like to convert it to a fixed rate. Or maybe your home has increased in value, and you’d like to harvest some of your home’s equity with a cash-out refinance. Finally, you might just be trying to save money on your momently payment or the total cost of borrowing.

Other Factors to Consider

Here are a few background questions to ask before you think about refinancing:

  • What is your loan to value ratio? Is it higher than 80%? If so, you will need to pay PMI.

  • Has your credit score recently improved or worsened? You’ll get better rates with a higher credit score, up to a point.

  • Is your current mortgage rate fixed or adjustable, and the adjustable term is about to start? If you have an adjustable-rate mortgage, check when your fixed term ends. For many, that may not be for 7 or 10 years. In those cases, the urgent need to refinance is not as great. But if your adjustable period is getting closer, considering refinancing is a good idea.

  • Can you qualify for a new mortgage at a lower rate or convert your adjustable rate to a fixed rate.

After reviewing these questions, we can think about how long you plan to stay in your current home or keep your mortgage. Just like when you first applied for a mortgage, you will need an appraisal and all the additional (and ridiculous) fees that go along with a mortgage. To recoup these fees, you calculate the savings on your new loan. Then divide the fees by your savings, and you determine how many months it costs to break even.

The last two years have seen a remarkable appreciation in home values, 20% growth or more in many areas. If you are currently paying PMI on your mortgage, now is a great time to re-evaluate.

Even without refinancing, if your loan-to-value ratio (LTV) has dropped below 80%, you can get PMI removed from your payment. This alone will save you a significant amount each year. Banks and lenders will do their assessments of your home value, and needless to say, it won’t match your report on Zillow!

Consider All of your Debt when Looking at Options

Finally, are you trying to reduce your monthly payment, or are you trying to reduce the overall interest paid on the loan? For those of you early in your careers, freeing up cash to invest or pay down student loan debt makes sense.

Or taking some of the equity out of your home to repay student loans. If you itemize on your tax return, your mortgage interest is deductible. In contrast, your earnings are too high as a physician to deduct student loan interest (which is a paltry $2500 per year anyway!)

My wife and I didn’t buy our first home until almost seven years into practice. We had a mountain of student loan debt we prioritized paying off. Thankfully we saved a ton on rent and paid off all our student loans in five years! The extra cash flow in those early years was beneficial. Plus, saving up for your first down payment is its own challenge. Saving $100K or more takes time, no way around it.

Early in your career, there are many competing interests on your income. Debt repayments, retirement savings, plus all the ‘getting caught up on life’ stuff that happens when you’ve been a student or resident for years! Slowing down, evaluating priorities, then making decisions based on what is most important to you and your family! This is why personal finance is personal.

All this said many people are sitting on 3-4% mortgages. Selling or refinancing is a more challenging decision in the current interest rate environment unless there is a strong reason, like relocating for a job or education. These next few months will be an interesting time to watch what happens to the housing market!

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