Refinancing the right way is not always as straightforward as it sounds. Over the years I have witnessed so many friends refinance for all the wrong reasons. There are certainly times when a home refinance makes financial sense but just tapping into available equity because your home went up in value is not a great reason. I have witnessed people tap into their equity every few years and all this did was extend the life of their loan and guarantee they get to retirement with a mortgage payment: something I am very much against.
“The smartest financial decisions are the ones that protect your stability, not your lifestyle.” Marketplace.org
Very recently, I was contacted by someone for financial advice. He currently has a home mortgage of $500,000 at 2.25%. His home is worth $1.1 million and he wanted to access $100,000 of extra cash. He had just been approved for a cash-out refinance for a loan of $600,000 at 6.875%.
I immediately put a halt to this refinance and silently chastised the loan officer for protecting his or her commission versus offering sound guidance. It seemed simple enough but the issue is resetting the entire $500,000 loan at a much higher interest rate. This decision would literally cost hundreds of thousands of dollars……all to access $100,000.
This post isn’t about never refinancing. It is about refinancing for the right reasons like building wealth or improving your financial situation. In this case a home equity line would make a lot more sense.
The Hidden Cost of Refinancing a Great Mortgage
In this example, the interest rate is 2.25%. That is unbelievable and, quite frankly, a pandemic induced rate. I personally do not believe we will ever see 30-year rates this low again without some other global crisis. This rate is so strong it can almost be viewed as an asset. These days you earn more than 2.25% on your savings (although that is decreasing as the Federal Reserve continues to lower rates).
To pause for a second, I want to explain Net Tangible Benefit and the two main types of refinances:
Net Tangible Benefit
Back in the financial crisis in 2008, if you had a pulse you could refinance your home (or buy a home for that matter). Ultimately this put a lot of people in harms way so home lending standards tightened. One rule that came out of this era is the Net Tangible Benefit (NTB) rule. It means a refinance is supposed to improve the borrower’s financial situation in a clear, measurable way. Lowering your interest rate, shortening your term (changing to a 15-year term), removing mortgage insurance are examples that qualify.
There is a catch though:
Cash-out refinances automatically qualify because the borrower is receiving money. As we discuss above, this does not mean the cash-out refinance is the best move or even a smart move.
A lower payment also qualifies for NTB even though the lower payment might be the result of stretching out the loan term to the original 30-year term. If you have 20 years remaining on a 30-year mortgage, refinance the remaining amount back to a 30-year term will very likely reduce your monthly payment but is almost guaranteed to increase the total interest you pay……by a lot!
So yes, there is a rule designed to protect you. Lenders must document this benefit in your loan documents. There are huge gaps though so don’t assume NTB means a refinance is a wise move.
Rate/Term Refinance
These simply reset the rate and/or the term of the loan. These transactions will result in a lower monthly payment. That lower payment is the result of a lower rate, a longer payment term or a combination of both. I am not a fan of getting to a lower payment by only extending the term of the loan because you are forcing yourself to have debt for a longer period of time and much higher total interest paid. Total interest is documented in your loan documents but many loan officers aren’t necessarily up front about highlighting this negative component.
“A lower payment doesn’t always mean a cheaper loan.”
I want to quickly point out that most people talk about 15 and 30-year terms for home loans. There are 20 and 25 year terms so think about these when you refinance. If you have only made payments for 1 year before refinancing, a new 30-year term is not harmful but, if you are 5 years in, perhaps ask about these other terms with your lender.
Cash-out refinance
This refinance restructures your original loan but at a higher amount. The difference in the original loan amount and the new loan amount represents the amount paid to you in cash (less fees). Generally, on any given day the rate for a cash-out refinance will be higher than a rate/term refinance.
The scenario I open this post with is a cash-out refinance:
- Old loan: $500,000 at 2.25%
- New loan: $600,000 at 6.875%
This is not borrowing the cash needed at a higher rate. It is replacing your $500,000 of really inexpensive debt into expensive debt and adding another $100,000 on top of it.
Doing some rough math:
- Total interest paid on a $500,000 loan at 2.25% over 15 years is $89,576.
- Total interest for that same loan amount at 6.875% would be $303,000 for 15 years! Using a 30-year term, the total interest expense jumps to $682,000………all to access only $100,000. Crazy!!!!!!!!!!!!!
The right solution in this instance is to secure a home equity line. The higher interest rate would only apply to the $100,000 thus saving a great deal of money. Note this is still expensive but certainly better than the math discussed above. Over 15 years, the interest for the equity line would be $61,000. While this is certainly preferred, this individual is spending $61K to access $100K.
Why Refinances Are Appealing
Refinances are tempting for many reasons:
- Home values continue to rise. This increases the equity people have in their homes. On paper, people are worth more.
- Lenders are constantly reaching out advertising ways to access the equity in your home. I have multiple properties. They are all at very low interest rates. After the pandemic ended, mortgage rates skyrocketed and there were not a lot of homes being sold. Lenders were not doing as much business so they pushed cash refinances. I was getting an email every day letting me know how much cash I could access.
- Monthly payments, not total interest, are what a lot of people focus on. If you have 15 years remaining on a 30-year loan and you refinance that amount over a new 30-year term, your payment will likely go down but the amount of interest you pay dramatically increases.
- Having one payment with a refinance can seem easier to deal with than having a mortgage payment and a HELOC payment.
What Really Happens When You Refinance
For those not overly familiar with the legalities behind a refinance, I am taking a step back to clarify:
- Your original loan is paid off and closed. In the example above, that $500,000 loan at 2.25% no longer exists after a refinance.
- There are generally closing costs with a refinance: lender fees, appraisal (if necessary), any escrow items (when property tax and/or home insurance is included with the monthly mortgage payment). These can be offset if there are any lender credits but are generally rolled into the new loan amount unless the borrower chooses to pay them.
- A new loan is opened for the amount of the former loan plus any closing costs plus any cash out amount.
- This entire new loan amount will have a new interest rate and a new maturity date.
Another Alternative: HELOC or Home Equity Loan
If you need to access some of the equity in your home AND your current mortgage is at an attractive rate much less than current rates, a Home Equity Line of Credit (HELOC) or Home Equity Loan can be a better option. Both options allow you to keep your current mortgage and only borrow the incremental amount you need.
Home Equity Line of Credit (HELOC)
- Works like a credit line that you can draw on as needed.
- You only pay interest when you draw on the line.
- Most have a 10-year draw period where you can access the funds. During the draw period, payments are interest only, but you can choose to pay more.
- After the draw period, you can no longer access the funds and any amount due is paid back over the next 20 years.
- Rates are variable and will change as the Federal Reserve makes changes.
Home Equity Loan
These are less common. Unlike the HELOC, the Home Equity Loan is for a specific amount, usually has a fixed rate and fixed monthly payments. This is good if you know you only need a certain amount, want a fixed payment and don’t necessarily want to access the availability on a regular basis.
Both of these are considered a ‘second’ on your home because they take a lien against your house but the priority of this lender comes after the bank holding the primary mortgage.
One Smart Exception (maybe) Even If Current Refinance Rates are Higher
When rates are higher than your current rate, cash-out refinances are not usually a smart financial move. One exception is if you are pulling money out to invest in a wealth building asset. I have investment properties and most, if not all, of the downpayments on those properties were financed one way or another. For me, they were not via refinance but the concept is the same.
This can make sense for you if:
- The new property will either a)generate positive cash flow after you consider all expected expenses along with the incremental financing cost from the refinance OR b)the property is at least close to cash flow neutral but is expected to increase substantially in value.
- You have a longer-term view of this asset given you signed up for a new mortgage at a higher rate. If your aim is to flip an investment, a home equity line would make more sense as you can borrow and pay it back as soon as you resell the asset.
- It is important to include all expenses when evaluating investment properties. Interest, property taxes, any HOA or POA fees, at least a 5% budget for repairs and maintenance, etc.
Accepting a higher rate to help grow your wealth over the long term is okay. What you shouldn’t do is refinance at a higher rate for lifestyle purchases that might feel great at the time but harm your financial position.
When Refinancing Makes Financial Sense
There are many instances when a refinance makes sense. Some examples are:
- You are lowering your interest rate significantly. What is significant depends on where you live and your loan balance. You will often hear people say not to refinance if the rate decrease is at least 50bps (e.g. from 7% to 6.5%). That is not necessarily bad advice but if you only owe $50,000 the 50bps probably won’t justify all of the costs of the refinance. On the other hand, if your mortgage is $1,000,000, a half point represents savings of at least $320 per month.
- I am starting to be repetitive but note that there are mortgage time frames less than 30 years. I do not recommend refinancing to a 30-year mortgage if you have already made 5+ years of payments. Yes, your payment will go down but this is because you have extended the time frame of your loan. The goal is to pay off your mortgage, not to keep extending it. Let’s use my $1m example. If you had this same mortgage but had made 5 years of payments, you will have approximately $975K of interest expense remaining. After 5 years of payments, you will owe $940,000. Refinancing that amount over 30 years at 6.5% does save you over $700 per month but your total interest increases to $1.19m, costing you $144,000 more interest in your lifetime.
- Your refinance eliminates Private Mortgage Insurance (PMI) or FHA mortgage insurance premium (MIP). These are incremental monthly payments attached to lower down payments.
- You are refinancing out of an Adjustable Rate Mortgage generally when rates are on the rise. This can give you some longer-term stability.
- You are consolidating very high interest debt into a lower rate mortgage. Make sure you do NOT run that debt up again!!
When Refinancing Is a Bad Move
On the flip side, there are many instances when a refinance does not make sense. Here are some examples:
- The rate on your current mortgage is much lower than the new rate.
- You are restarting the 30-year clock after paying on your current mortgage for 5+ years. As mentioned, you can consider 15, 20 or 25 terms to offset this issue.
- Any cash out funds are going towards short-term lifestyle spending vs bettering your future.
- You have not factored in all of the costs of the new loan including total interest on the new loan along with closing costs.
Questions to Ask Before You Refinance
Based on the information above, before you commit to a refinance make sure you ask yourself some basic questions:
- If this is a rate/term refinance, am I reducing the total interest cost with the new loan?
- Am I giving up a historically low interest rate (e.g. the 2.25% 30-year rate that launched this post)
- If taking cash out, is this cash helping me build wealth or simply helping to acquire things/lifestyle.
- If total interest is increasing, is this transaction helping build long term wealth or for lifestyle purchases?
- Have I considered whether a HELOC or home equity loan makes more sense?
- How does this refinance impact my monthly cash flow and long-term goals?
Final Thoughts
A lot of information was presented in the post. At the end of the day only you can decide whether a refinance makes sense for your situation. If you are sitting on a mortgage in the 2-4% range, you are holding something extremely valuable so I would recommend you try to protect this.
“The smartest financial decisions are the ones that protect your stability, not your lifestyle.” Dave Ramsey
Refinancing can be a powerful move when it lowers your rate, reduces your total interest expense or helps you acquire a true wealth building asset. Just make sure your decision supports the life you are trying to build not the lifestyle you are trying to uphold.
This is ultimately what I hope Money & Inspiration is all about: helping you make intentional, informed choices that create financial freedom.
For more on how home loans work at the most basic level, you may want to read The Very Basics of a Home Loan
