Mortgage Loan Refinance Guide

Is it Time to Refinance?

So how low do rates have to go to justify a refinance? The standard answer heard most often is 2% without any additional qualifications. Unfortunately, that answer has done a great disservice to millions of consumers for decades. In reality 2% may not be enough and 1% could be more than enough reason to refinance. Sure, right about now you are scratching your head trying to figure out where I am going with this. Let’s start by addressing a few fundamentals about mortgage financing that will allow you formulate a logical conclusion when considering refinance options.

It’s Not Just About Interest Rates

First it is important to know that interest rates cannot be considered in a vacuum. In other words, just because lender (A) has a rate of 4% and lender (B) has a rate of 5%, does not automatically make lender (B) inferior. That is because one must consider the corresponding closing costs that go along with the quoted rate. Closing costs consist of charges controlled by the financial institution (origination fee, discount, underwriting, processing, doc. prep fees, etc.) and associated service providers (Title company, attorneys, appraisers, surveyors, credit bureaus, etc.). Closing costs should not be confused with Pre-paids which are taxes, insurance, mortgage insurance and prepaid interest. Prepaids should never be part of the lender comparison process as they are existing costs associated with the house and will have to be paid independently of the refinance.

Now, consider that not all closing costs are equal. Some closing costs are variable and depend on the loan amount and others are fixed. For example, origination and discount points are normally a % of the loan amount and so the dollar value goes up as the loan amount goes up. Other costs such as appraisal fees, processing and underwriting fees are normally fixed on most loans. Therefore, regardless of whether you have a $250,000 or a $50,000 loan, fixed costs stay the same in terms of dollars. But as a percentage, fixed costs represent a larger part of the total costs as the loan amount decreases and vice- versa. For example, a $350 appraisal fee is only 0.14% of a $250,000 loan amount, but 0.70% of $50,000. Therefore, we can derive that in general, as the loan amount goes up, the actual dollar costs go up because of the variable costs, but the total closing costs as a percentage go down because of the fixed costs and the converse is also true.

Breakeven Analysis

A good understanding of closing costs is important, because one of the main considerations in determining whether a refinance is feasible is based on a break-even analysis. The breakeven point (BEP) reveals whether you will be in the house long enough to recoup your investment in terms of closing costs paid to do the refinance. The BEP is expressed as the number of months it will take from the monthly interest savings you will achieve (Current Interest Rate – Proposed Interest rate) to equal the amount of closing cost you paid to do the refinance. Therefore, if you have the cash readily available and it is languishing at a rate of return that is less than the savings you will obtain from the lower interest rate by refinancing (all other things being equal), or there is sufficient equity in the property to roll in the closing costs into the new loan amount, then the refinance from an interest rate point of view makes sense as long as you are planning to stay in the house longer than the BEP. Conversely, if you are planning on moving before the BEP, unless it is a potential CASH FLOW/Default situation which we will discuss later, the refinance will not be feasible as you will not have the new loan long enough to produce total savings greater than the amount of cash you invested to do the refinance.

Let’s look at an example and compute the BEP so that you can get a better feel for the relationship between Time, Closing Costs and Savings. We will assume your current interest rate is 5.5% and that you can currently refinance at a proposed interest rate of 4.5%. For simplicity’s sake, we’ll consider abbreviated closing costs of a 1% origination fee, a $350 appraisal fee and a $375 underwriting fee. Two different loan amounts of $100,000 and $200,000 will be considered. Let’s look at the $100,000 loan first:

A) $100,000 @ 5.5% produces a current principal and interest (CP&I) payment of approximately $565. (Your current scenario.)

B) $100,000 @ 4.5% produces a proposed principal and interest (PP&I) payment of approximately $504. (Proposed Refinance)

The difference between A) and B) is $61/month. The closing costs are $1,000 (1% Origination Fee) + $350 + $375 for a total of $1,725. The BEP is expressed mathematically as Total Closing Costs/(CP&I –PP&I) or $1,725/61 = approximately 28 months. Therefore, if it takes 28 months to recoup the $1,725 invested to do the refinance, excluding other considerations, one may safely conclude that on the basis of interest rate, the refinance is a smart thing to do if you are going to live in the property more than 28 months, but not feasible if you think you will be selling the house in the next 28 months.

In the next loan scenario:

A) $250,000 @ 5.5% produces a (CP&I) payment of approximately $1,412.

B) $250,000 @ 4.5% produces a (PP&I) payment of approximately $1,261.

The difference between A) and B) is $151/month. The closing costs are $2,500 (1% Origination Fee) + $350 + $375 for a total of $3,225. The BEP is $3,225/151 = approximately 21 months. Therefore, if it takes 21 months to recoup the $3,225 invested to do the refinance, excluding other considerations, then one could conclude that the refinance is a smart thing to do if you are going to live in the property more than 21 months, but not feasible if you think you will be selling the house in the next 21 months.

Now, you may have noticed that the BEP shrunk 7 months on the larger loan. Why? Because, remember that your closing costs as a % of the loan amount are actually decreasing as the loan amount increases. Therefore, an interest differential of 1% represents a greater costs savings in relation to the % of closing costs on larger loan amounts than on smaller loan amounts. And that is why I stated in my introduction that “2% may not be enough and 1% could be more than enough reason to refinance”.

Here let me prove it to you with another example. In this scenario, both borrowers have well over 40% equity and will be moving due to a job transfer in 20 months.

A) Borrower (1) has a $40,000 loan amount at 6% and is considering a new proposed interest rate of 4% (A 2% differential). Using the same closing cost structure we used above, the total closing costs will be$1,125. At 6% the P&I = $238 and at 4% the P&I=$190 for a savings of $48/month. Break-even using the formula above is approximately 23 months. Therefore, even with a 2% differential, the refinance cannot be justified due to the move in 20 months.

B) Borrower (2) has $400,000 loan amount at 6% and is considering a new proposed interest rate of 5.0% (A 1% differential). Using the same closing cost structure we used above, the total closing costs will be$4,725. At 6% the P&I = $2,386 and at 4% the P&I=$2,138 for a savings of $248/month. Break-even using the formula above is approximately 19 months. Therefore, borrower 2 only needs a 1% differential to justify the refinance.

The Equity Factor

But of course, things are never that simple. There are several other considerations which one must take into account aside from interest rates. One critical factor is mortgage insurance, which is required when the borrower equity is less than 20%, and is used to offset losses by the lender in case of borrower default. On conventional loans it is called Private Mortgage Insurance (PMI) and on FHA loans it is called Mortgage Insurance (MI). If the proposed refinance results in having to obtain PMI or MI because there is a consequent reduction in equity, then the added cost of the PMI/MI must be considered in the BEP calculations. PMI/MI is based on a sliding scale that is determined by equity and credit scores. The higher the LTV (Loan-to-Value or the ratio of the Loan Amount to Appraised Value) and/or the lower the credit score, the higher the PMI/MI costs. Therefore, it is possible that a refinance could lower your interest rate by 1% but erase most or all of the benefits by having to add mortgage insurance costs of 1% or more.

Let’s look at the above example on the $400,000 loan with a payment savings of $248/month. The analysis assumed equity of 40% or more. But what happens if equity drops below 20% (The drop could be due to a devaluation of the property, the rolling in of closing costs and prepaids, pulling out equity, etc. ) so that the LTV is now 90% and PMI or MI is now required at an added cost of 0.94%. Your transaction now takes on a totally different meaning in terms of feasibility. In this example, the $248/month savings is now offset by an additional $313/month in added expense! So if you only look at interest rate, you may be saving money, but when you look at total cost in terms of rate + PMI/MI, you are losing money and the whole BEP concept is a mute point. Therefore, I cannot stress enough how important it is to do the math and discuss the pros and cons carefully with your mortgage professional as sometimes the end results may not be intuitive.

Risk-Based Pricing

Another important consideration is that for years now, rates and closing costs are not equal for all people. What? That smacks of discrimination! Well it would be if the rate was somehow influenced by race, color, religion, sex or sexual preference, but it is not. In today’s modern and highly technological world, rates and closing costs are a function of pricing models that reward or penalize based on the level of perceived risk. Therefore, if you have 800 credit scores and 50% equity in your house, you will get a better rate and closing costs than someone with 630 credit scores with less than 20% equity in their house. Below is a sample list of other factors that affect interest rates and closing costs:

· Purchase or a refinance loan

· Rate-term refinance or your are wanting to take cash out (cash-out refinance).

· Property is a SFR or multi unit.

· Property is owner occupied, a second home or investment property

Therefore, don’t get too bent out of shape if you and your neighbor bank at the same bank, go to the same branch and you both walk out on the same day with completely different rates and closing costs.

When Interest Expense is Not the Objective

But sometimes, cost and savings are not the objective of a refinance. In fact, it may make sense at times to refinance from a lower rate to a higher rate. As a consumer, you may have obtained a 15 year mortgage years ago when the economy was at its height and you were making a lot more money. Perhaps you or your spouse have experienced a reduction in work hours, lost a job or suffered a catastrophic illness resulting in enormous medical bills. In the aforementioned cases, the main objective of a refinance may be cash flow, reducing your monthly payment so you can continue to make payments and preserve your credit. Therefore, refinancing from a lower term 15 year mortgage (even if at a lower interest rate) to a 30 year mortgage (even if at a higher interest rate) may be the solution. As long as the mortgage does not have a prepayment penalty, you can continue to pay extra towards your loan to stay on track for paying off the loan in 15 years, but when money is tight on any one month, you can always fall back on the much lower 30 year payment without being barraged by cacophony if collectors.

Another example of why you might want to refinance to a higher rate is that you may need to consolidate much higher interest debt (i.e. credit cards, unsecured personal loans, liens, etc.) or need capital for a fantastic business opportunity or a great real estate deal and you want to tap the cash tied up as equity in your home without your payment increasing. But again, never assume anything, do the math and see if the numbers bear out what your instinct is telling you. There may be tax consequences, penalties and early redemption fees that complicate the analysis. Always research, there may be better alternatives to the refinance. If you are not a math/finance person, then talk to trusted professionals such as financial advisors, CPA’s, and mortgage consultants. In the end, the advice you receive could end up saving you thousands of dollars.

Reality Check

Finally, keep in mind that even when a refinance makes sense, is justified mathematically and fits perfectly with your short and long term financial objectives, it may just not be possible to execute. Credit requirements are higher today than they have been in decades. Debt-to-income ratios are being carefully scrutinized with lenders paying close attention to discretionary income. And even if credit and income are strong, there may not be enough equity in the house to do a loan, and if there is, you may have to bring several thousands of dollars to the table for closing costs and prepaids, making the transaction impossible to close.

In conclusion, as in any financial transaction that involves large sums of money, when considering whether to refinance in a declining interest environment where everyone seems to be doing it, it is best to practice discretion, don’t jump in too fast or completely based on intuition. Reach out to your trusted mortgage professional and other financial experts, taking the time to go over the math until it makes sense. It may be a little cumbersome and far from anything that may resemble fun, but in the end, it could save you a lot of money and put you closer to your financial objectives.