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Refinance when income changes

February 23, 2022

What is the first thing that comes to mind when you think of a refinance? The effort and costs are probably not worth the benefit. You would be right most of the time as refi's can cost at least 1-2% of your loan amount. With interest rates starting to climb beyond 4% the time for a refi may have already passed. A rule of thumb is that a 1% decrease in interest rates merits a refi to offset the costs of getting a new loan. But, let us not jump to an answer so fast. In life, and in the finances of your home, making the right decisions a few times and then sitting back to reap the rewards can make a world of difference. Here are two not so obvious reasons to refinance when your income levels change drastically.

First, If your income has dramatically increased (>50%) after a job promotion or change, it may make sense to consider a shorter mortgage. The two main factors that determine the affordability of your monthly payment are interest rates and length of loan. Both are significantly lower for a 15 year mortgage. A 30Yr Fixed loan of $400,000 at 4% costs $1,910 in principal and interest. Whereas, a 15Yr Fixed loan for the same amount will be ~$2800 at a likely lower interest rate of 3.25%. If your gross monthly earnings climbed from $8,000 to $12,000, your monthly mortgage payment to income ratio would actually fall from 24% (1910/8000) to 23% (2800/12000). In spite of adding almost $900 to your monthly expenses, you are actually reducing the percentage of income towards your mortgage expense. The benefits are huge! You will own your home twice as fast, and you will also save ~$181,000 in long term interest expenses.

Second, If you've recently quit your job or transitioned from a dual to single income household, refinancing could help reduce your monthly mortgage payment in three ways. Let's take the same example of a $400,000 loan at 4% and assume you are 5 years into your mortgage.  

  1. Your principal balance is now $361,800 or about 9.5% less. A refinance will lower you monthly P&I by $103, from 1910 to $1807
  2. An interest rate reduction in your favor will help. If interest rates are at 3.5%, your monthly P&I will further drop by $179, from $1807 to $1731
  3. You can also delete any private mortgage insurance (PMI) you were paying after dropping below the 80% Loan to Value ration. In other words, you likely have more than 20% equity after a few years of price appreciation and principal paid.

If all assumptions above are true, you will realize a net increase to your monthly cashflow of $432 (103+179+150).

Lastly, you could also consider the the time value of money. If so putting real estate taxes and home insurance in a 1% interest bearing savings account may make sense to you. On $8,000 of annual taxes and insurance, that would only amount to $80, but if you are in-between jobs, every cent helps. A refinance is not required to exit escrow, but escrow is required when PMIs exist. So, if you are deleting PMI, it's about the time you can decide to not escrow. I recently transitioned from a job to becoming an entrepreneur. My family is using a mix of these strategies to manage short term cash outflows. While lowering monthly payments temporarily is useful, it is not the fastest or cheapest route to building equity in your home. The point is that a home loan should adapt to its users needs, not the other way around. A refinance is an option for flexibility when life changes.

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