How to Survive a Recession

LESSON 29: Refinance Your Home

If you are a homeowner, your mortgage payments are normally your largest cash expense. Reducing you home loan payments by refinancing at a lower rate can contribute significantly to your overall budget.

As an economic recession deepens, it is common for the government to reduce interest rates incrementally over several years. With every lower rate cycle, there is an opportunity for savings by obtaining a new loan at a lower rate and paying off the old higher-rate loan. If you intend to own the property for a long period (greater than 2-5 years) it is best to obtain the lowest fixed-rated loan with the longest repayment term as possible. This locks in the low interest rate for future periods when the economy strengthens and the property value grows.

The key to home refinancing is to refinance only when the net costs including fees, broker commissions, and penalties are exceeded by the net savings over the intended financing period of the loan. There are many free online calculators that will help you make this decision. For example, suppose you are paying 7.5% on a $150,000 10-year fixed rate loan, for a total cash outflow of $1781 per month. You are offered a 6.5% 10-year fixed rate loan, which would drop your payment to $1703 per month, but you would incur $2500 in up-front points. Refinancing would save $78 per month over the life of the loan. It would take you 47 months to recoup the $2500 paid up-front. If you had the $2500 cash, and planned to hold the property for 10 years without refinancing again, this would be a good decision. An option would be to finance the broker points, avoid the up-front cash outflow, and amortize the cost over the life of the loan. This would result in decreased monthly payments of $1732 for a $49 per month savings, without any up-front cash outflow. A good decision.

You must consider cash outflows during the investment term, how long you intend to finance or hold the property, whether interest rates are falling or rising, expected equity growth, brokerage fees, alternative financing arrangements, and other costs and penalties. What if you only intended to hold the property for 2 years? If you had to pay $2500 in points up-front, you would not do the deal because you could not recoup the $2500 in 24 months. As you can see, investment value is not the only factor.

If you intend to hold the property as an investment for less than 2-5 years, consider an adjustable-rate mortgage (ARM) that has a lower interest rate in the near term, and a higher rate beyond that. For example, you might pay 5.25% fixed for 2 years, then the rate increases automatically to Prime plus 2%. Although ARMs are blamed for a large part of the mortgage lending crisis, they still have their place if you plan properly and are careful to build in sufficient cash flow margin in case rates move up quickly. With an ARM the lender is betting that interest rates will increase beyond the initial period of the loan. If interest rates go up, you can sell the property, having made lower payments during the holding period than if you had a fixed-rate loan. If the recession is long, the government is likely to keep interest rates low, and you can either refinance the ARM at a fixed rate after your intended holding period is over, or keep the ARM which will adjust up, but not as much as originally contemplated.

An ARM is essentially a bet that interest rates will continue to fall and remain low for 2-5 years. If interest rates remain low, your payments will remain low and the lender will not realize extra profits from upward rate adjustments.

A fixed-rate mortgage is a bet that today’s interest rates are as low as you can reasonably get and rates will rise in the near future. With a fixed-rate mortgage you want to lock in a low fixed rate for as long as possible when long term rates are very low.

By doing your research, calculating the numbers correctly, and putting in extra effort you can refinance your home loan properly and generate additional free cash to use for other purposes.