When mortgage rates are low, it’s a smart move to pay down extra principal to qualify for a lower mortgage rate. This could give you a high return on your capital. However, when mortgage rates are high, like they are today, paying down extra principal might not be the best financial move.
Let’s look at an example. I once tried to refinance my 5/1 jumbo ARM mortgage. I was paying $4,338 a month, with about $2,192 going towards the principal. If I had managed to refinance to a 2.375% rate, my monthly payment would have dropped to $3,830, with $1,900 going towards the principal. This would have increased my cash flow by $508 a month, but my monthly principal payment would have decreased by $292 a month.
Unfortunately, I couldn’t proceed with my mortgage refinance due to a high debt-to-income ratio. I was over the limit of 42% set by most banks. The irony is that if I had managed to refinance the mortgage, my debt-to-income ratio would have dropped, making me more creditworthy.
The solution was to pay down principal to qualify for a mortgage refinance. In this case, I would have had to pay down a whopping $181,000 in principal. This was a tough decision, as I only had about $190,000 in liquid savings at the time. But if I had paid down this amount, my monthly mortgage payment would have dropped to $3,160 from $4,338, improving my cash flow by $1,178 a month.
Before you decide to pay down extra principal to qualify for a mortgage refinance, there are eight things you should consider:
- Your liquidity situation: How much money in the bank makes you feel financially secure?
- Upcoming purchases or expenses: Will you need to buy another property, replace your car, pay private school tuition, or cover medical expenses soon?
- Investment opportunity cost: In a bull market, you want to have as much risk-asset exposure as comfortably possible.
- Interest rate outlook: Will interest rates decline or increase in the future?
- Real estate outlook: Do you plan to own your property for the long term?
- Income stability: Do you have a recession-proof job?
- Net worth composition: Is your net worth heavily invested in real estate?
- Return on principal pay down: What is the return on paying down extra principal?
In conclusion, always do the math before refinancing. It’s worth paying down extra principal to qualify for a mortgage refinance. You won’t regret paying down debt and lowering your interest cost, even if you could have made more investing.
