The Arbitrage Between your Mortgage Interest Rate and Market Returns
Given historical low interest rates and a drop in the 10-year yield from even a year ago, we are often asked:
- Should I refinance?
- Should I pay off my mortgage?
- How much should my loan be and what terms do you recommend?
Our answers are usually two-fold; there’s a financial decision and there’s an emotional one, and we are here to help you find the balance that works for you and allows you to sleep at night. For many of us, it has been ingrained in our minds to avoid debt at all costs. Leverage within reason can be very beneficial to your overall financial picture.
When considering the use of a mortgage versus payment of cash for a new home, it can be important to understand the arbitrage between the interest rate you will pay to borrow the money, and a conservative estimated rate of return for your investable assets. You may have the resources and desire to pay off a mortgage loan, as many of us aspire to be debt free, but this doesn’t always make the most financial sense.
In each of the following types of mortgages, a conservative 60/40 asset allocation (average annual 10-year return of 6%) can yield positive net returns over time.
This scenario in the table below is for the home buyer who is deciding whether to use available cash, access their investment account, or obtain a mortgage. The numbers demonstrate that an environment with low interest rates and a conservative return, offers an opportunity to arbitrage between higher investment returns and the cost to borrow.
The benefits are clear in both short and long-term time periods, given this current market environment. However, we understand there is often an emotional component around debt, and the most prudent financial decision, may not always be the best decision for you.
Reasons to Refinance Your Mortgage
At some point during your mortgage term, you may consider refinancing your current loan. There are many reasons why a homeowner may be interested in a refinanced loan; to consolidate debt, take advantage of better interest rates/terms, or take some cash out against the equity in your home. It is not uncommon to be real estate rich and cash poor. Given the appreciation in real estate over the past 20 years, we are finding that clients are looking to access the equity in their homes.
Obtaining a Lower Interest Rate
One of the most popular reasons for refinancing a current mortgage is to take advantage of interest rates that are lower than your original loan. This decrease in rates can come from an overall drop in the average interest rate or an increase in the borrower's credit score. It is vital that when looking into refinancing at a lower interest rate, you take into account the closing costs and fees that will be associated with a refinance to make sure it is worth the switch.
Unfortunately, debt such as credit cards and high-interest loans can result in a significant amount of interest paid during the repayment period. Many homeowners use their home to pay off this debt and repay the money at the lower mortgage interest rate. When considering this option, be sure to calculate the amount of interest you will pay throughout the life of your mortgage, and see if this repayment method will be the most cost effective for your finances.
Change the Mortgage Term
When you first buy your home, loans are often determined by how much you are approved for, how long you think you will be living in the home, and what you can afford for a monthly payment. As with anything in life, your situation can and often does change. You may find yourself wanting to refinance your mortgage to shorten the term of your loan, pay less interest over time, and pay off your loan earlier. If you are having a harder time affording your current payment, you may consider refinancing to extend out the term of your mortgage and reduce your payment to make it a better fit with your current budget.
No matter the reason, refinancing your mortgage could be a good option for you either to reduce your monthly payment or to take advantage of an arbitrage opportunity to earn more on your money. In any case of refinancing, there can be considerable closing costs that are important in determining the net benefit. It is important to research and consider all the factors before making your final decision.