Refinancing your mortgage in 2021 and beyond is a no brainer because interest rates are back down to six-year lows. Check out Credible, one of the largest mortgage lending marketplaces that allows you to compare multiple real rates and lenders in one place.
To no surprise, my 5/1 jumbo ARM refinance has run into a snafu. For those who don’t know, I’m trying to refinance a 2.625% 5/1 ARM in its 5th year into another 5/1 ARM at 2.375%. If I let the ARM adjust after the 5th year, it may adjust to 3.375% or higher since the rate is based off LIBOR + a 2% margin. Everybody who has an ARM close to adjusting needs to refinance.
The mortgage amount is $981,000 and I’m currently paying $4,338 a month. Roughly $2,192 of the $4,338 monthly mortgage payment goes to principal. If I were to successfully refinance to a 2.375% rate, my monthly payment would fall to $3,830 a month, and $1,900 of the payment would go to principal. In other words, my cash flow increases by $508 a month, but my monthly principal payment goes down by $292 a month.
I enjoy paying down principal every month because it’s like a forced savings account. My goal is to pay off the entire mortgage by age 50 (2027), or 22 years after I first took the sucker out. Once a mortgage is paid off, there’s only one figure needed to calculate your net worth: the market value of the property.
Unfortunately, I’m unable to proceed with my mortgage refinance given my debt-to-income ratio is too high. Most banks have a debt-to-income ratio limit of 42%, and with a $981,000 mortgage, I’m over that. The irony is that if I were to successfully refinance the mortgage, my debt-to-income ratio would drop, making me more creditworthy because my income would go up by $508 a month.
With the combination of buying another property in 2014 and paying myself a modest salary from my online business, I just don’t qualify for refinancing the full $981,000 amount. Instead, I only qualify for refinancing $800,000.
I screwed up by paying myself a lower salary in January of this year than my average monthly salary I earned in 2015. As soon as an underwriter sees a lower salary, they begin to extrapolate a permanently lower salary, or a salary that is variable, both of which are no good.
Paying down $181,000 worth of principal is a lot because I’ve only got about $190,000 in liquid savings at the moment. But if I were to pay so much down, my monthly mortgage amount would drop to $3,160 from $4,338 originally for a $1,178/month cash flow improvement.
Given I’m not bullish on stocks, real estate, or private equity over the next two years, I’m not looking to invest more than my normal $5,000 – $20,000 a month cadence based off cash flow. Therefore, the chances of the $181,000 just sitting in my money market account for the rest of the year remains high. A 2.625% return is better than a 0.2% money market return.
Finally, I have a 7-year CD coming due. I’ll also receive my final tranche of deferred compensation as part of my severance package then as well. It’s kind of crazy I’m still getting paid from my old employer five years later. If there is such a thing as being overly liquid, I’ll be entering that territory if I don’t pay down any extra principal this year.
If you’re considering paying down extra principal to qualify for a mortgage, here are eight things to think about before making a decision.
1) Liquidity situation. Ask yourself how much money in the bank makes you feel financially secure. The answer is different for everybody. I like having six months of living expenses in the bank at a minimum. The rockier the times, the more I want.
2) Upcoming purchases or expenses. Do you want to buy another property? Will your car need replacing soon? Will you be having to pay outrageous private school tuition? How about upcoming medical expenses? If your monthly cash flow can’t take care of your expenses on its own, then paying down extra principal might not be a good idea.
3) Investment opportunity cost. In a raging bull market, you want to have as much risk-asset exposure as comfortably possible. In the 7th year or later of a bull market, having a balanced portfolio of stocks, bonds, and risk-free assets is more prudent. I just can’t get too excited about anything right now except for perhaps venture debt and P2P lending yielding a realistic ~7% annual return.
4) Interest rate outlook. There are two things involved with a successful mortgage refinance: 1) locking in an interest rate that makes sense, 2) passing the underwriting process. I was able to lock in a rate 0.125% off the all-time low I’ve seen for 5/1 jumbo ARMs. I do believe interest rates will stay low for a long time, but I just don’t know whether I’ll be able to time the bottom again. Here’s my argument for why you should get an ARM versus a 30-year fixed mortgage.
5) Real estate outlook. If you plan to own your property for the long term, it doesn’t matter whether the real estate market is increasing or declining. But if the length of ownership is less than forever, then you need to make an educated guess on the probability of a real estate meltdown occurring during the window when you plan to sell. If there’s greater than a 50% probability, you shouldn’t pay down extra principal because you may never get your money back.
6) Income stability. Do you have a recession-proof job? Or are you in a highly unstable and cyclical business? Everybody should refinance before losing their W2 income because you become dead to banks once you are unemployed. At the same time, nobody should be tying up excess capital into their illiquid homes if their jobs is at risk. The more streams of income you have, the more income stability you have as a result.
7) Net worth composition. Don’t put all your eggs in one basket as the saying goes. If real estate accounts for significantly more than 50% of your net worth, consider staying liquid or using your capital to invest elsewhere. The downturn punished a lot of homeowners because more than 80% of median homeowners’ net worth was in real estate. You can easily see a snapshot of your net worth composition if you aggregate your accounts with Personal Capital.
8) Return on principal pay down. During the previous housing crisis, a lot of people had to do a “cash-in refinance” to pay down principal to get their loan-to-value ratio back down to 80% or lower in order to qualify for a refinance. Back then, the interest rate spreads were significant e.g. a homeowner locked in a 6% 30-year fixed rate before the crisis, but could refinance to 4% if they got their LTV down. In my situation, I’m only talking about a 0.25% difference not a 2% difference.
Because my cash flow increases by $1,178 a month or $14,136 a year if I pay down my mortgage from $981,000 to $800,000, I could say that my return on $181,000 = 7.8% ($14,136 / $181,000). Or, I can take my old annual interest payment ($981,000 X 2.625% = $26,000) – new annual interest payment ($800,000 X 2.375% = $19,000) / cash-in amount ($181,000) = 3.8% return. Or I can simply calculate the return based on the interest rate I am refinancing = 2.625%.
2.625%, 3.8%, and 7.8% returns all compare favorably to the current risk-free rate of return of ~1.75%. The question is whether you’re willing to take more risk to get an even greater return.
Everybody should come up with a debt pay down plan. Once you have a plan, you’ll figure out ways to achieve your goal. My plan is to be done with this originally $1,220,000 mortgage by age 50. If I pay down an extra $181,000 in principal to qualify for my 2.375% rate, I’ll have 11 years left to pay off the remaining $800,000 balance.
I have zero regrets paying down an extra $200,000 in principal on a rental property in 2014 and 2015. It’s now mortgage-free and I couldn’t be more satisfied. Some people have said it’s unwise to have so much capital locked up in one asset. That’s true if the asset accounts for a significant portion of your net worth. This rental property is less than 15% of my net worth, and will hopefully continue to decrease with an increase in the overall pie.
70% of me is leaning towards paying down extra principal in order to lock in 2.375% for the next five years. I’ll be cash poor for a couple months, but knowing me, I’ll switch my hustle engine into overdrive to rebuild my warchest.
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Updated for 2021 and beyond.