Opting to pay down additional principal to qualify for a mortgage refinance can be a wise decision when mortgage rates are low. By doing so, you could potentially reap significant returns on your capital.
To illustrate this, let’s consider a scenario where paying down mortgage principal for refinancing proved beneficial. The true return on reducing your mortgage is equivalent to the interest rate, but that’s not where the benefits end.
In one instance, while refinancing my 5/1 jumbo ARM, I encountered an obstacle. I was moving from a 2.625% 5/1 ARM in its fifth year to a new 5/1 ARM at 2.375%. Without refinancing, the rate would have adjusted to 3.375% or higher. My mortgage was $981,000 with monthly payments around $4,338, of which approximately $2,192 went towards principal.
By refinancing to a 2.375% rate, my monthly payment would drop to $3,830, offering a cash flow improvement of $508 per month. Although, this would slightly reduce my monthly principal repayment.
I value paying down principal as it acts like a forced savings plan. My aim is to fully pay off this mortgage by age 50. When a mortgage is fully paid off, calculating net worth becomes simpler, relying solely on the property’s market value. However, paying off a mortgage early can sometimes lead to a decreased motivation to earn more.
High Debt-To-Income Ratio: A Refinancing Challenge
My attempt to refinance was hindered by a high debt-to-income ratio, typically capped by banks at around 42%. With a $981,000 mortgage, I was exceeding this limit. Ironically, refinancing to a lower rate would have improved my debt-to-income ratio. A combination of purchasing another property and maintaining a modest salary from my online business meant I couldn’t refinance the full amount, only up to $800,000.
To proceed, I faced the tough decision of paying down $181,000 in principal. This was a substantial portion of my liquid savings at the time. However, this payment would reduce my monthly mortgage to $3,160, improving my cash flow by $1,178 monthly.
Given my lukewarm outlook on investment opportunities at the time and my consistent investment rhythm of $5,000 – $20,000 monthly, the likelihood of that $181,000 remaining idle in a money market account was high.
Calculating the Return on Principal Reduction
The return on paying down additional principal is calculated by dividing the annual interest savings by the principal reduction amount. For instance, a 2% savings on an $800,000 mortgage equates to $16,000 yearly. This results in an 8.9% return on a $181,000 principal reduction, which is a substantial gain.
Before deciding to pay down extra principal, consider factors like liquidity, upcoming expenses, investment opportunity costs, interest rate forecasts, real estate outlook, income stability, net worth composition, and the specific return on principal pay down.
Each refinancing situation is unique, and doing the math to understand your specific circumstances is crucial. In my case, I don’t regret paying down an extra $200,000 in principal on a rental property, leading to a mortgage-free asset that now forms a smaller percentage of my overall net worth.
The Bottom Line
Paying down additional principal to qualify for a mortgage refinance can be a smart move. It not only helps in reducing debt but also lowers interest costs, contributing positively to your financial health.
