Last week, a friend texted me to ask for advice on whether to refinance her home, which she had purchased a year ago. Since she had purchased her home, interest rates had dropped as a measure to stabilize the COVID-ravaged U.S. economy, and people everywhere were scrambling like hungry teenagers in a snack food aisle, looking for opportunities to refinance their homes.
Before we begin, let me make something clear. The point of this story is not to share with you the exciting adventures of my unnamed friend and her possible refinance. The point is to illustrate the simple idea that every financial decision can be analyzed based on its effects on your Three Pillars of financial health: liquidity, cash flow, and net worth.
My friend’s particular situation was as follows: By refinancing, her interest rate would drop by 1.3% and reduce her monthly mortgage payment by $250-300. There would be no upfront costs, but the principal would increase by $11,000 and the mortgage would end one year later, since the 30-year term would restart.
Her other friend had advised her not to refinance, since the costs of refinancing were not worth the $11,000 tradeoff. She wanted my thoughts on what to do, since she knew that I was a real estate investment enthusiast who had been around the block a few times before.
As a professional educator in personal development, I don’t like providing answers. Instead, I prefer to provide others with frameworks and questions that help them figure out their own answers. Teach them to fish.
I told her I’d consider the effects on the Three Pillars of financial health: liquidity, cash flow, and net worth.
Let’s analyze each in turn:
1. Liquidity
In my friend’s case, her liquidity wouldn’t change at the time of the transaction because there were no upfront costs. In other words, her access to liquid capital would be the same, since she wouldn’t be paying out anything to refinance, and also did not intend to cash out in this refinance.
Of course, refinances are generally built so that a bit of cash comes out at the end, as a buffer for unexpected last-minute costs and to leave customers with a warm, fuzzy feeling after doing business with Loan Depot, Loan Factory, Loan Craftsperson, Loan Shark, or whichever Loan _____ you just dealt with. But we decided to ignore that factor, since it’s minimal.
In her particular set of circumstances, then, liquidity was a draw, and would not be a factor favoring either refinancing or not.
2. Cash Flow
Let’s get into factors that would change. As she noted to me, her cash flow situation would change favorably by about $250–300 per month.
The great thing about cash flow is that it powers the other two pillars of financial health. As Dave Ramsey says, your income is your most powerful wealth-building tool. Dave takes the idea to what some would consider an extreme, avoiding debt altogether to free up as much cash flow as possible.
Even if you don’t listen to Dave Ramsey, it is certainly true that cash flow helps you build up liquidity, and it can also help you build your net worth by borrowing to purchase, say, buy another investment property.
In the early years of my career, I overvalued net worth, and paid too little attention to liquidity and cash flow. I got lucky — no financially crippling calamity ever hit, and my optimization for net worth paid off well. However, now in my Eight Year of Moneymaking (not counting the bits of income during college and law school), I now clearly see the value of liquidity and cash flow in helping individuals weather the craziness that happens, like, oh you know, once-a-century pandemics. Now, I ensure that my income is at least about double of my monthly expenses, in order to preserve net cash flow and thereby build liquidity and net worth.
Score one for refinancing — my friend’s refinance would leave her better off in terms of cash flow.
3. Net Worth
The refinance would cost my friend $11,000 in costs, financed as part of the mortgage balance. Clearly, this is a negative that counts against refinancing, and was the reason my friend’s other friend advised against refinancing.
But here’s the wrinkle — as mentioned above, cash flow powers net worth, even if that means socking away the increased cash flow under a mattress and not investing a penny. So this is where we need to bring the factors together to understand how it all shakes out.
Bringing It All Together To Decide
So far, we have:
- The immediate impact on liquidity as a neutral factor,
- The effect on cash flow over 30 years as a positive, and
- The immediate impact on net worth as a negative.
How do we square cash flow against net worth? How do we know what factor wins out in the end?
Since the loss in net worth is a one-time event, whereas the cash flow benefits persist over 30 years, the most relevant question is: What is the time frame she would expect to keep the mortgage?
If she intended to keep the property for a long time, the improved cash flow would eventually make up for the costs in around 5 years, even if she simply saved the difference and made no effort to invest the cash or leverage her cash flow to make even more money.
On the other hand, if my friend were to keep the mortgage for less than that crossover point, the improved cash flow might not make up for the $11,000 hit to her net worth. In that case, I told her, she could think about her current needs and decide what was more important at the moment.
We could have gone into the math of how to decide that particular part of the transaction, but luckily it wasn’t necessary. She responded to my question on timing by saying that she planned to keep the mortgage for a long time, almost certainly more than 5 years. And that was that. She had arrived at her answer.
In addition to sharing this story to illustrate the usefulness of breaking down financial decisions into their effects on the Three Pillars of financial health. I hope this framework will likewise help you think more clearly about your own financial decisions.
