One of the themes of my book is that rules-of-thumb are a very bad foundation on which to base decisions about your mortgage options. I recently completed a refinance for a client that perfectly illustrates the importance of thinking through the goals and concerns of the client before generating options and then choosing one.
Beth is a typical high-tech worker in Silicon Valley with a nice suburban tract home. She had a loan on it with a fairly high interest rate because she had simply not had the time to explore refinancing it during the refinance boom of 2013. Rates are low again, as you know, so she thought she would look into it.
She also had a small equity line that she had acquired when she helped her son finance his education. She wanted to consolidate her two loans into one but keep the equity line open so that she could do some work around the house.
The Thinking Starts
But I noticed a couple of issues that were important. First, her equity line didn’t have very far to run before it recast – the point at which she could no longer draw on it and had to begin making fully-amortized payments. Keeping the current equity line wasn’t going to benefit her for long.
Moreover, if we consolidated all of the debt into one loan the new loan would be considered a “cash-out” loan. Her loan-to-value ratio was high enough that this would have raised her interest rate 0.250%. That may not seem like much, but it amounted to an additional $1,250 a year or more in interest cost.
Besides this, Beth also wanted to pay off her mortgages before retiring in about 15 years. To this end she had been making additional payments on her existing first mortgage already.
After thinking about her needs and goals, I compared three options for Beth:
- Consolidating the loans into one loan
- Refinancing the first mortgage and then getting a new equity line
- Consolidating both into a new 15-year mortgage
Option 3 would have saved her tens of thousands of dollars but the minimum payment was uncomfortably high.
Comparing options 1 and 2 was an interesting exercise. Option 2 would have left her exposed (on a small portion of the debt) to interest rate fluctuations, because equity lines always have a variable interest rate. However, option 1 was considerably more expensive over the 15 years or so that she expected to be paying the loan.
Beth decided that she would take option 2, but with a plan. Rather than commit extra money to the first mortgage, she would commit extra payments each month to the new equity line, thus paying it down (very quickly I might add) and thus reducing her exposure to interest rate changes. Once she paid off her new equity line she would still have the line available for emergencies, but she could start making larger payments on her first mortgage to pay it off faster.
If she follows through with this plan, she will save about $15,000 in interest cost over the next 15 years compared to option 1, and the plan as laid out would get her to zero mortgage in 15 years if she can stick to it.
When you are thinking about refinancing for any reason, make sure you talk to your lender about your goals and concerns – not just about the proposed loan, but about your future plans. Why are you thinking about refinance? What is the most important goal you are trying to achieve? How do you expect to pay this back? What concerns do you have about this? If your mortgage advisor doesn’t ask these questions, listen attentively, and respond with options that address your most important concerns, find another one. And good luck, Beth!