For many people, a home is one of their largest assets. Also, because most people don’t pay cash to buy their home, they need to get a mortgage to finance the purchase. Even though a mortgage is typically 15, 20, or 30 years, that doesn’t mean everything stays the same during that time. What might be a great interest rate at the time of purchase could be considered a high interest rate just a couple years later. This is why millions of Americans choose to refinance their mortgage when interest rates go down. What’s important to keep in mind, though, is that there are many factors besides the interest rate that a homeowner should consider before refinancing. There are seven key considerations that one should review before applying for a refinance.
To help me understand what’s happening in the mortgage market, I reached out to my friend Phill Becraft. Phill is a mortgage advisor with Guild Mortgage and has more than a decade of experience in the greater Seattle area. Phill was able to provide insights into some of the key considerations outlined below.
Your Credit Score
Rates vs. Term
Private Mortgage Insurance
1) Your Credit Score
One of the biggest factors that lenders consider when evaluating an application is a borrower’s credit score. While current interest rates are at historic lows, that doesn’t mean everyone will qualify for these low rates. It’s helpful to know what your score is beforehand so that you’re not surprised when you apply for a refinance. A general guideline for getting the lowest mortgage interest rate is having a credit score of 760 or higher.
Tip from Phill Becraft:
“Online credit check companies are a great tool for consumer lending products, but in the end, they are a for-profit business. Don’t be surprised when a mortgage lender pulls your credit and it’s different by 20–30 points. Mortgage lenders use a more complex FICO scoring system for their reports to supply to their investors. It’s called FICO Score 9, and it’s on a different level than what is used at the online credit check companies.”
2) Refinance Costs (closing costs)
All borrowers should keep in mind that refinancing is not free. Even when lenders offer a “no-cost” refinance, that just means the rate will be higher to cover the costs of the refinance. Typically, a borrower should be prepared to pay 2%–6% of the total loan amount to refinance. That 2%–6% range should make it obvious that not all lenders are the same, and oftentimes it pays to shop around. If you’re worried about out-of-pocket costs, many lenders allow closing costs to be wrapped into the new loan—but you need to have enough equity in your home for this option to work.
Tip from Phill Becraft:
“If you refinance with your current loan servicer, you may not need to reestablish/rebuild an escrow account to ensure your property taxes and insurance are paid. This can lower your upfront or financed loan costs.”
3) Home Equity
If you want to refinance, then you should confirm that your home is worth more than the mortgage amount. The more the better, but a good target is at least a loan-to-value (LTV) amount of 80% or better. In other words, you should try to have at least 20% equity built up in your home.
Quick example: Home Value = $500,000 | 80% LTV = $400,000 | 20% Equity = $100,000
If your home is worth less than your current mortgage, that is considered “underwater.” When a home is underwater, your refinancing options are limited. Most conventional lenders won’t refinance a mortgage if the home is underwater, but a homeowner may be able to qualify with a government program. It’s always best to check with your lender first.
Another reason to have 20% equity is figuring out if you will be required to pay private mortgage insurance (PMI). We’ll discuss this more in a later topic.
Tip from Phill Becraft:
“Many conventional loans make you keep mortgage insurance for the first 24 months regardless if you have enough equity (20%+). Sometimes it’s best to look at a refi to get an updated appraisal to better your LTV or equity position.”
4) Debt-to-Income Ratio
Just because you currently have a mortgage, it doesn’t mean you can simply refinance into a new one. Lenders have not only increased their standards for credit scores, they’ve also become more stringent when it comes to your debt-to-income ratio. Ideally, your monthly house payments should be under 28% of your gross income, and overall debt-to-income should be less than 36%. This means you need to calculate how much your other monthly obligations are, such as car payments, credit card bills, student loans, and other credit lines when figuring out your total debt-to-income ratio. Having a steady job history, a high income, and some money saved are all helpful attributes, and some lenders may allow your debt-to-income ratio to go into the 40%+ range, but you shouldn’t count on that.
Tip from Phill Becraft:
“Childcare costs are not considered when looking at debt-to-income ratios. Also, some lenders can eliminate monthly liabilities like auto loans with less than six payments left.”
5) Rate vs. Term
Getting the lowest possible rate doesn’t always make the most financial sense. Many people looking to refinance put a lot of emphasis on the interest rate, but it’s also important to know the cost of getting lower rates. Make sure you pay attention to the refinancing points that are paid to get a mortgage at a lower interest rate. These points are either wrapped into the closing costs or added to the principal of your new loan.
Another way to get a lower interest rate is choosing a mortgage with a shorter term. A 20-year mortgage will typically have a lower interest rate than a 30-year mortgage. If your goal is to reduce your monthly payments, choosing a shorter-term mortgage will most likely result in a higher monthly payment. If your goal is to lower your monthly payment and pay off your mortgage faster, then you can refinance into a loan with a lower rate and the same term, but keep making the same amount you were paying on the previous mortgage. Let’s use an example:
Original Mortgage: $300,000 | 4.00% | 30 Year Term | Monthly Payment = $2,387
Refinanced Mortgage: $300,000 | 3.50% | 30 Year Term | Monthly Payment = $2,245
In the original mortgage above, the minimum payment of $2,387 is made every month for 30 years until the loan is paid off. Say you refinance into the new mortgage at 3.50%, but instead of making the new minimum payment of $2,245, you keep making the previous mortgage payment from the original loan, $2,387 per month. This strategy “feels” like your monthly payment hasn’t changed, but now your loan will be paid off in approximately 27 years instead of 30 years! You can save 3 years of mortgage payments by simply lowering your interest rate and sticking with your original monthly payment.
It’s important to note this simple example does not take into account closing costs, refinance points, or how long you’ve been paying into the original mortgage, but you should get the point that you can make payments above your minimum monthly payment. This strategy also allows you to reduce your monthly payments back down to the minimum amount during times that are financially challenging.
6) Private Mortgage Insurance
Most lenders require a borrower to have at least 20% equity in their home, otherwise private mortgage insurance (PMI) is required. Lenders will calculate your loan-to-value ratio during a refinance to ensure the mortgage amount will not exceed 80% of the home’s value. The costs for PMI vary and are typically 0.25%–2% of the loan balance per year. This means the higher the mortgage amount, the higher the PMI costs. For many homeowners, putting 20% down at the time of purchase is a big hurdle, so it’s not uncommon for PMI to be added to a mortgage. As home values increase, refinancing may be a way to eliminate PMI and get a mortgage at a lower interest rate. The opposite is also true, though. If your home has decreased in value, a lender may require PMI on a refinanced mortgage if the LTV exceeds 80%.
Tip from Phill Becraft:
“Did you know there are many ways to pay mortgage insurance? Gone are the days of monthly payments! You can choose “split” or “single” paid premium options with most mortgage brokers. Choose a small lump sum down and finance less each month (split) or just pay the single premium up front and don’t have any monthly MI costs!”
7) Break-Even Point
If you are considering refinancing your mortgage, you should at some point ask yourself, “Is it worth it?” This question cuts to heart of making this decision. Ultimately, you need to calculate if the costs to do the refinance will be paid off eventually by the monthly savings.
For example, if your refinance costs are $12,000 and you end up saving $400 per month, then it will take 30 months to “break even.” This means you should plan on staying in your current home for at least another two and half years, or you won’t end up saving anything by refinancing your mortgage.
Hopefully these seven considerations have given you enough “food for thought” to realize refinancing a mortgage is complex, and it’s not just about getting the lowest rate. Before you make the decision to start the process, I encourage you to speak with a professional who can help assess your financial situation and determine if now is the right time to refinance your mortgage. Here at Merriman, a Wealth Advisor can assist you with this decision as part of our financial planning process. Reach out today if you have any questions.
As a dad and a financial advisor, I find myself constantly trying to explain how money works. In my opinion; budgeting, investing, and creating income are topics that should be equally important to my 8-year-old daughter as they are to a 50-year-old client. Unfortunately, for whatever reason, access to financial literacy tools for money management are not a mainstream part of our educational system. With more and more resources available at our fingertips, it is my hope that the next generation will grow up already knowing how to save and plan for retirement way before they get their first job.
Take my daughter for example. Last summer, my then 7-year-old asked me what I do for work (I’m a financial planner). It turns out, her friends were all talking about what their parents did for a living, so naturally my daughter wanted to join in on the conversation. Up until this point I had always told her that I helped people get ready for retirement, which I summed up as a “summer vacation that never ends”. She didn’t give it much thought until other kids started talking about how their parents owned a restaurant, helped people get better as a doctor, or worked on getting packages delivered faster as an engineer at Amazon. When my daughter told her friends that her dad helped people get ready for a never-ending summer break, she got a lot of “Huh?” faces.
I then decided to have a more in-depth dialogue with my daughter around what I actually did. The basics of how investing works seemed like a good place to start. So, using the tools we had at our disposal (crayons, blank paper and a 7-year-old’s imagination) I set out to explain what a financial advisor does. It started with a simplistic explanation of what the stock market is, and by the end of our first conversation, my daughter had learned the rhyme: “Stocks make you an owner, and bonds make you a loaner.”
This was progress! After a few more arts-and-crafts sessions, we had created a story explaining how investing in the stock market works, and it was starting to resemble a book. At this moment, I told my daughter we should try to publish our book so other children could learn about investing, and she turned to me and said, “Dad, you can’t just publish a book. Only authors can do that!” Challenge accepted!
Fast-forward six months, and our rough draft was polished into a finished book. Today, you can find “Eddie and Hoppers Explain Investing in the Sock Market” on Amazon! As a dad and a co-author, I’m very proud of my daughter for helping me create this story and for helping me make the book a reality.
After the book came out, I figured my daughter would stay interested in financial literacy, but I should have known asset allocation and risk management weren’t exactly the most exciting topics for an 8-year-old. I had to find a way to introduce financial topics into everyday life.
Money management for a second-grader is pretty simple. My daughter’s main income sources are: A monthly allowance, gifts from relatives for birthdays/holidays, plus she had a lemonade stand last summer that netted a respectable profit. The problem wasn’t earning the money, the problem was keeping track of it and then remembering how much she had when she wanted to buy something.
So, as a dad/financial advisor, I did what comes natural… I created a spreadsheet to track everything. Turns out, spreadsheets are also pretty low on the list of things that my daughter finds interesting. This is when I had my a-ha moment. I did a quick internet search and found a lot of options for tracking how much a kid earns, spends and saves. Last summer when I was trying to teach my daughter what I did for a living, I did a similar search for children’s books that discuss financial topics and found very little. That’s what inspired me to write our book. Thankfully, this time I was able to find what I was looking for when searching for an app that could help me teach my daughter about budgeting.
Ultimately, I decided to use Guardian Savings with my daughter because it has the right balance of simplicity and effectiveness. Guardian Savings allows my wife and I to be ‘The Bank of Mom and Dad’. My daughter finally got organized, and she consolidated all her savings from the half-dozen wallets, piggy banks and secret hiding spots, so she could make her first deposit. More importantly, when we’re at the store or shopping online and my daughter finds something that she must have, we’re able to open the app and let her see the impact of making an impulsive purchase. Plus, as the parent, I get to decide what interest rate my daughter will earn in her account. Not only do I get to have a conversation about what interest is, but she gets to experience the power of compound interest by seeing her savings grow each month. Talk about a powerful motivational tool!
In this day and age, the idea of teaching your child how to balance a checkbook is outdated. The next generation will live in an entirely digital world. Apps are the new checkbook, and it may be a good idea to teach your children personal finance in the same environment they will be in as adults. Already a digital native, my daughter impressed me by how fast she learned how to use the app, not to mention the principals of saving and smart spending that are encouraged throughout the interface. In a few years, I’ll be able to discuss what asset allocation is and how a Roth IRA works, but for now I’m happy that my daughter can get practice making budgeting decisions and building a strong understanding of the basics. Financial literacy has to start somewhere and the sooner that foundation can be made, the more confident a child will be when it comes to managing money as an adult.
With all the recent changes to the U.S. tax code, it’s a good time to revisit different tax planning strategies. One strategy I’m often asked about is whether a Roth conversion is a good idea. The universal answer to that question is “maybe.” Unfortunately, there isn’t a simple rule of thumb that applies to everyone. There are many factors that need to be examined, and my goal is to tell you the most common reasons you might want to do a Roth conversion.
Before I do that, it’s important to note a particular change in our tax code with the passage of the Tax Cuts and Jobs Act (TCJA) of 2017. In the past, a recharacterization was done if you needed to “undo” the Roth conversion. Starting in 2018 and beyond, this is no longer allowed for Roth conversions. An exception is if you make a Roth contribution, and then learn that you earned too much income during that year. A recharacterization will still be allowed in this case so that you’re not subject to the excess contribution penalty tax. (more…)
If you work at a company like Facebook, Amazon or Microsoft, a large portion of your total income is probably made up of restricted stock units (RSUs). After tackling your savings goals, there might not be a lot left over in your paycheck, so you may be asking yourself the following question:
How do I use my RSUs for income and spending?
At Merriman, we take our clients through a discovery process to learn about goals and lifestyle. Through that process we often discover total income may be made up of more than just a salary. To ensure our clients are hitting all their savings goals for early retirement, vacations and higher education, we need to create a plan for how to use multiple sources of income. For example, we may need to figure out what to do with RSUs, how to effectively use an employee stock purchase plan (ESPP) and how to invest annual bonuses. Mapping out a month-by-month plan helps our clients get organized and feel confident they’re taking the right steps toward saving enough and achieving their goals. Having this peace of mind allows guilt-free spending with the money that’s left over each month.
I recently met with a couple, Scott and Julie, who needed help creating a plan for their monthly cash-flow needs. At first, putting together a monthly budget seemed simple enough, but for Scott and Julie, it became clear it would be more complex because of their different income options. We had to figure out what to do with their income from salary, when to sell RSUs and how to take advantage of their company’s ESPP.
To create a plan that balanced their income vs. expenses, we took a three-step approach.
Step 1: Optimize savings options.
Each contributes $19,000 per year to their 401(k).
Each contributes to their ESPP to take advantage of the discounted share price.
Each makes contributions into their after-tax 401(k) so they can take advantage of the Mega Backdoor Roth. (Note: This is not available at all companies.)
They contribute monthly to a 529 college savings plan for their two kids.
Step 2: Calculate what the income gap is each month.
After they meet their savings goals, pay their taxes and take care of other miscellaneous payroll items, their monthly income from their paychecks equals $10,000.
Their monthly expenses are -$15,000, so this leaves them with a monthly deficit of -$5,000.
Step 3: Sell RSUs and ESPP shares to supplement income.
Below is a spreadsheet that shows a month-by-month cash-flow plan for their “spending bucket,” which is their checking account. Notice we first filled the bucket with $50,000. This initial $50,000 came from the sale of some of their RSUs. At the beginning of each month, you can see the starting amount gradually go down. We refill the bucket every quarter by liquidating more RSUs, and then every six months we sell shares in their ESPP.
We never want the bucket to go to $0, so we make sure there’s a buffer every month. Also, it’s important to note that this spreadsheet does not show what we’re doing with their annual bonuses or remaining RSUs. Without going into too much detail, those excess income amounts could be saved or used for guilt-free spending.
Income from paychecks continue to fill the bucket, and when the amount gets low we refill their spending bucket using the proceeds from selling their RSUs and shares in their ESPP.
Because they’re on track to hit all their savings goals, they can put their annual bonus in their “live fully” bucket and use it for dining out, vacations and other guilt-free spending.
Each year we’ll review how the actual cash flow went. If it turns out spending was a little higher, then we’ll adjust how much of their RSU proceeds are used for cost of living needs. If they spend less than we anticipated, we’ll instead invest more of their RSUs.
The complicated budgeting that we helped Scott and Julie put together is something we’re doing more and more for clients who work in tech. Here at Merriman, we get it. While working 50+ hours a week, it’s tough to find time to ensure you’re efficiently saving in all the right ways. It’s our job to help you keep your financial plan on track and so you can enjoy your life. In other words, our goal is to help you Invest Wisely and Live Fully. Feel free to contact us if you’d like to learn more about how to implement a customized cash-flow strategy that fits your compensation plan.
Figuring out how much risk to take in a portfolio can seem like a simple calculation, but for most people, emotions tend to make the process more challenging. On the surface, we all know risk is a necessary component of investing, but finding the right amount of risk to achieve our goals is more complicated than just picking a number between one and ten.
There are many factors that determine how risky an investment is. (more…)
An important part of helping clients achieve their financial goals is helping them navigate questions and decisions around Social Security and Medicare. Whether it’s deciding when to start Social Security or applying for supplemental Medicare coverage, these decisions have a big impact on your financial situation and wellbeing.
This book is broken up into two parts, as Social Security and Medicare are complex topics. The first covers Social Security and strategies. The second part covers the ins and outs of Medicare and all its various plans.
We hope you discover strategies and new things that will help you make the best decisions for your situation. As always, we’re here to help and answer any questions you may have.