Many federal employees and retirees are concerned about their Thrift Savings Plan (TSP), IRAs, and non-retirement investment accounts as a result of the recent stock market downturn related to the COVID-19 pandemic crisis. But as result of the downturn in the US economy also related to the COVID-19 pandemic crisis, the Federal Reserve has reduced short-term interest rates.
The reduction in short-term rates has led to a reduction in long term interest rates, including mortgage interest rates. A question that has arisen for many federal employees who currently have first mortgages on their primary residences: Is now a good time to refinance one’s mortgage in order to take advantage of the lower mortgage interest rates?
There perhaps has never been a better time to refinance one’s mortgage, and there may never be as good of an opportunity again. This column discusses some of the more important issues associated with refinancing a mortgage on a primary residence.
Record Low Mortgage Interest Rates
First it is important to discuss the record low interest rates. According to the latest market survey data on primary mortgages released by Freddie Mac on April 30, 2020, the 30-year fixed rate average fell to 3.23 percent. Last year around this time the 30-year fixed rate average was 4.14 percent. The 15-year fixed rate average has dropped below 3 percent, down to 2.77 percent. Last year around this time the 15-year average was 3.68 percent. These current 30-year and 15-year mortgage fixed rates are the lowest levels in the history of Freddie Mac’s survey which goes back to 1971, almost 50 years ago.
Until recently, high demand for housing in most markets has resulted in high valuations. The Federal Reserve Bank of St. Louis says the average sale price of a home in the US during the fourth quarter of 2019 was $382,300, a little lower than the all-time high valuation of $399,700 in the fourth quarter of 2017.
Lower mortgage interest rates, high housing valuations coupled with record high individual Fair, Isaac, and Company (FICO) scores (the average FICO score hit a record high of 703 in 2019) make mortgage lenders more friendly to potential mortgage loan refinancers.
Now may also be a good time for federal employees who are thinking about retiring from federal service within the next two or three years to refinance a mortgage. They should refinance while they are still getting a paycheck in order to help them get approved for a loan. Once they retire and they no longer are receiving a paycheck every two weeks, it could be a challenge to qualify for the best interest rate on a traditional mortgage.
4 Questions Before Going to a Mortgage Lender
Given that now may be a good time for employees to refinance their mortgages, an employee is encouraged to ask the following four questions before going to a mortgage lender to apply for a new mortgage:
1. What is the cost to refinance and how long will it take to get my refinancing costs back?
Refinancing a mortgage is not free. There are closing costs that will be charged by the mortgage lender and other parties involved in the closing, including the settlement attorney and the settlement company.
Other typical expenses associated with a refinancing include an appraisal, title, fees, flood certification, plus points, if the homeowner is “buying down the interest rate”. Once all of these costs are determined, a homeowner can weigh these costs against the lower monthly house payment to determine if a refinancing is worth the cost of refinancing, or in other words, how long one would have to pay the lower monthly payment in order to recover the refinancing costs. That is, to determine the so-called “payback period”. Consider the following example:
Frank and Carol have a 30-year 4 percent $400,000 mortgage that has 25 years left on the mortgage. They are looking to refinance the amount currently left on the mortgage ($380,000) to a 30-year mortgage at 3.4 percent. Frank and Carol found out from their lender that the cost to refinance is $4,600. The following analysis shows how Fran and Carol calculate their “payback period”:
This means that, assuming Frank and Carol plan on staying in their house for at least 20 months, it is worth for them to refinance their current 4 percent 30-year mortgage to a new 3.4 percent 30-year $380,000 mortgage. But if they are thinking about either selling the house and netting more than $380,000 or possibly refinancing again within the next 20 months, they are advised to stick with their current 4 percent 30-year mortgage.
2. Do I want to go from a 30-year fixed mortgage to a 15-year fixed mortgage?
The current average 2.77 percent interest rate on a 15-year mortgage loan looks very appealing. However, associated with a 15-year mortgage loan is the higher monthly payment. That higher monthly payment may not be affordable. An alternative is to take the 30-year term mortgage with the higher interest rate but lower monthly payment and, when possible and affordable, make extra principal payments each month.
In Frank’s and Carol’s example above, if the extra principal payments are regularly made each month, then it is possible that their current 30-year mortgage could be paid off in as little as 15 years and 9 months. However, if the homeowner’s financial circumstances change and he or she cannot afford to make the extra monthly principal payments, then homeowner can reduce the monthly mortgage payment back down to the minimum amount required by the 30-year mortgage.
3. Do I want to simply refinance the current principal balance on my existing mortgage at a lower interest rate, or do I want to “cash out” and refinance for more than the current principal balance at a lower interest rate?
Many financial advisors would advise their clients to refinance the amount currently left on their existing mortgage. However, some homeowners may be better off asking for whatever extra cash they can get (before exceeding the 80 percent loan-to-value ratio, which could trigger the need for private mortgage insurance, which can be expensive).
The extra proceeds from a refinancing “cash out” could – and perhaps should – be used to pay off any higher-interest rate installment or personal debt such as credit cards or car loans, or be used to fund a planned home remodeling project which will improve the value of the house.
4. Am I better off paying off the current mortgage rather than keeping the mortgage and perhaps taking on more mortgage debt?
If a homeowner is close to retiring, then the homeowner is encouraged to pay off as much debt as possible. This is especially the case if the homeowner can do so without tapping into tax-sheltered accounts like the Thrift Savings Plan (TSP), IRAs, and annuities, or selling assets that would trigger a capital gains tax.
Not having a mortgage payment each month means that a federal annuitant may not have to tap into their TSP account each month to help pay the mortgage. Deferring the payout of the TSP and traditional IRAs means perhaps fewer taxes early in retirement. Not having to make a mortgage payment could mean postponing the start of one’s Social Security benefits. Delaying the start of Social Security retirement benefits means earning “delayed retirement credits” (DRCs) and guaranteed higher monthly benefits (8 percent more year until age 70) until Social Security monthly retirement benefits are started.
Some homeowners may balk at paying off the mortgage because of the loss of the mortgage interest tax deduction. It is important to understand that homeowners can only deduct mortgage interest if they itemize on their income returns instead of taking the standard deduction. Since the standard deduction for 2020 is $24,800 for married couples filing jointly and $12,400 for single filers, plus an extra amount for individuals over age 65, many annuitants may not have enough itemized deductions to exceed the standard deduction amount, even when they include their mortgage interest.
Given the limit on state and local income and property taxes of $10,000 per year (which are part of itemized deductions), it is not surprising that many annuitants, especially those ever age 65, do not itemize on their federal income taxes. For these individuals, a mortgage refinancing to a lower interest makes little sense, especially when it comes to saving on federal income taxes.