Successful Refinancing - An Example of the Issues, Computations, and Thought Process

With rates having dropped in recent weeks, it seemed a good idea to go over the thought process behind a successful refinance. Other than the two issues, of loan to value and whether you're really able to qualify for a traditional mortgage loan, things are pretty similar to other refinancing mini-booms. I've seen some people claiming that you should go up to forty-five day rate locks instead of thirty, but I must disagree. With underwriting times at five days, you should not need longer than a thirty day rate lock (or purchase escrow) if you and your loan officer have your act together. Purchase loans go through different underwriters at most lenders, and they have no right of rescission. Even in summer 2003, when refinance underwriting was at 33 days, purchase loans were still getting turned in no more than four, and funded in two to two and a half weeks. Even refinance loans can still be done in under 30 days - if your loan officer submits a complete clean package to begin with, something there's no reason not to do in the case of a refinance. Furthermore, if you make a habit of submitting nice clean complete packages, underwriters will start cherry-picking yours out of the pile when they don't have enough work time left for a piece of garbage. You can't really control this or count on it, but it sure was nice to have the loans come back approved in three or four days, when the competition was taking four weeks. My median last year was seventeen calendar days from lock to fund - adding five days of underwriting only brings us to twenty-four (Don't forget the weekend), and that's forgetting that underwriting was talking a day or two even then. Longer rate locks are more expensive, so you don't want to pay for what you're not going to need. But you do have to have your ducks in a row from the beginning to make it happen.

There are two component costs of getting a loan done. The first is closing costs. This is what is necessary to pay all of those people that work on your loan. Appraisal, escrow, title, notary, processor - not to mention things like credit report charges and recording fees, and in some states, taxes levied upon mortgages. I knew things were getting cheaper with virtual escrow and flat rate title insurance upon refinances, but it was just a few days ago I really looked at how much this was. It's now running much lower than the $3400 rule of thumb I've been using. I quoted two yesterday, and the higher added up to just over $2800. Of these, the only ones that usually need to be paid in cash are the appraisal and the credit report. There are certainly lenders who offer to pay for the appraisal, but I've gone over the traps there before. The others can be rolled into your loan balance. Unfortunately, you'll be paying interest on it there so it's not something I like to recommend, but it can be done, and if you need to do it, it's part of the calculations on whether you should refinance. Actually, it's a part of that, either way.

The second part of the costs are in the points. Actually, this separates into origination and discount, where origination is more properly a closing cost, but most providers (including me!) quote origination and discount together in points verbally, but points of origination is computed exactly the same as points of discount, and when they're disclosed in writing on the paperwork, they add up to the number quoted, at least for the more ethical providers. Note that unless that quote is backed up with something like a Loan Quote Guarantee, these numbers don't mean anything you can hold the lender accountable for, so signing up for a backup loan is a really good idea.

If you choose a higher rate, the lender might not only not charge points, they might cover part or all of your closing costs.

There are other potential costs as well. If your current loan has a prepayment penalty, you can figure you're going to end up paying it in order to refinance. There are only four ways to get out of paying a prepayment penalty, and the two best are not having one or waiting for it to expire. The standard pre-payment penalty is six months interest, so if you've got a $200,000 loan at 6%, you can figure paying that penalty is going to cost $6000. Some penalties are only 80% of that amount, but either way this can entirely change the computation as to whether it's worthwhile to re-finance, and I can think of half a dozen instances off the top of my head where the client swore that they didn't have a pre-payment penalty - but they did. Sometimes this is a rude awakening as to whether the loan officer who got you that loan however long ago really did as good a job as you thought they did. In the illustrated case, it also adds $6000 to the cost of refinancing until it expires. This isn't the fault of your new loan officer - unless they're also the one who did your current loan, they had nothing to do with it. People have gotten angry at me to no good purpose any number of times on this point, when that pre-payment penalty had nothing to do with me. I didn't put them into that loan, I didn't put the loan contract with a pre-payment penalty in front of them, I didn't sign the contract without understanding it, and I certainly didn't get paid for doing that loan. Kind of like trying to blame your neighbor for the crimes of Attila the Hun.

There are other things that need or might need to get paid. Every refinance loan has thirty days interest attached to it. But this isn't a cost; it's only money you would have paid anyway. Some lenders will roll it into the loan and tell you that you "skip" a payment. This may be technically true, but is nonetheless incredibly dishonest. It's much more correct to say "you made one mortgage payment a little earlier." You never really skipped a payment, you only keep the money in your checking account because you added the amount of the payment to your balance. And of course, there's the impound account if you want one, to pay your taxes and homeowner's insurance. Avoid rolling this into your balance if you can.

Just because rates are lower now doesn't mean it's necessarily worthwhile to refinance. Let's work with an example. Let's say the property is valued at four hundred thousand - that's what the current appraisal will come in at. Current loans sum to $260,000, at six percent. No pre-payment penalty, the clients don't want an impound account (be thankful for the one thing the California legislature has done right in the last twenty years). Total closing costs, $2800. Plus whatever cost in points or minus whatever rebate you can get.

Here are some options available a couple days ago (Rates actually dropped again today), all retail rates for thirty year fixed rate loans:

at 6.125, a rebate of 7/10ths of a point or $1820, cutting closing costs to about $1000. But there's no benefit whatsoever to doing that. Not only does the cost of interest go up if they get this loan, they've spent $1000, and the cost of interest goes up to $1332.19 per month from $1300 even, assuming you roll it that $1000 into your balance, but even if you don't, you're not cutting your cost of interest. Unless you're in some kind of loan that's going to somehow get worse, like if the current loan is adjustable, there's no reason to do that. There's no benefit whatsoever, even though the overall tradeoff between rate and costs is now lower.

5.875% was retail par, no rebate but no points to get it either. Total cost $2800. Let's assume you pay it out of pocket, so your balance stays the same and you actually cut your cost of interest by $27.08 per month. Would you pay $2800 in order to save $27.08 per month on your mortgage? I wouldn't. Even without considering the time value of money, it takes 103 months - over 8.5 years - to break even. Most folks don't keep their loans three years, let alone eight, and if you haven't broken even by the time you sell or refinance, you're just out the money.

at 5.625%, you would have paid half a point. Assuming you pay it out of pocket, that's $1300. Added to $2800, that's $4100. You cut your cost of interest to $1218.75, so you're saving $81.25 per month, but when you divide it out into $4100, that works out to 50 months, not counting time value of money. I probably wouldn't invest $4100 for that, but some rational people with a long record of keeping loans ten years or longer might think it was a good investment.

At 5.375%, you would have paid 1.5 points - roughly $3900. Added to $2800, that's $5700. If paid out of pocket, it cuts your cost of interest per month by $135.42, which divides out to a breakeven of 42 months - three and a half years. It's not that good if you roll it into your balance - cutting your monthly interest savings to slightly less that $110, and your breakeven is moved back to essentially 52 months, still not considering time value of money. I wouldn't do that, but it doesn't mean there aren't rational people who would.

Notice that all of these rates but one are lower that what these people have now, but in no case have I been enthusiastic about the refinance from the client point of view.

You may have noticed I haven't used payment to compute any of this. That's because payment is much less important than most people seem to believe. Yes, you need to be able to make the payment, but with that said, You should never choose a loan based upon payment. Even if you were paying off other debt with payments of hundreds of dollars per month, you shouldn't choose your new loan based upon payment. Focus on the real costs of money - what money you need to spend to make the change, the difference it makes to the monthly interest. Even if you have a real cash flow problem you need to solve because you are barely able to make your current payments, you'll go a lot less wrong by focusing on cost of interest.

However, let's see what happens if these folks have forty-five thousand dollars at an average of eleven percent in consumer debt they want to pay off. True that the monthly payments are $800 and it's really crimping them. They're just barely making all the payments every month, and if anything happens like, say, a car repair bill, they'd be completely hosed. That is another reason for doing something, but it's not a reason to focus on payment, but only to make certain that the new payment falls within the range of what they can really pay. As it sits, their real ongoing cost of that money is $1300 plus $412.50, or $1712.50 per month. Many people will tell them that consolidating that debt moves it from non-deductible to deductible, but a strict reading of the tax code says that is not the case (deductible interest is based upon purchase price, normally amortized). I'm not going to tell you that people haven't gotten away with this deduction, but the IRS has had their eye on enforcing it of late, so I'm not going to assume you're getting a deduction out of it, and in fact, I'm going to assume the deductibility issue is a wash.

We haven't changed the basic rates, which are the sum up to the conforming loan limit (currently $417,000). Paying off consumer debt makes it into a "cash out" loan, and a balance that includes paying $305,000 of debts puts you over a seventy percent Loan to Value Ratio, possibly over eighty if you choose a high cost loan and or roll impound accounts into your balance as well. The lender whose sheet I got this from has a
adjustment - an additional charge for risk - of half a point for cash out loans between seventy and eighty percent of value, 3/4 of a point for 80% and over. So all of the above rates have their costs increased by half a point.

So 6.125% now only carries a rebate of two tenths of a point. The moderately good news is that this is on a larger amount of money, and the closing costs are the same (I deliberately picked these numbers so that the cost for the lender's policy of title insurance stayed the same on a refinance, but it usually won't) But I'm also going to presume that you don't have the money to pay these cash out of pocket - you have no choice but to roll loan costs into your balance. After all, if you had thousands of dollars sitting around cash why do you have all of these consumer debts? I'll still have you paying prepaid interest out of your pocket instead pf pretending to "skip" a payment, and no impound account, but you don't have the cash to pay everything out of pocket.

At 6.125, your closing costs are still $2800, and the slightly over $600 rebate you got means that the balance only increased to about $307,185. Total cost, of refinancing to you, $2185. Monthly interest charge is now about $1567.93 - so you're saving $144.57 in real money per month, never mind that the payment is going to have a much larger difference. Would you spend $2185 to make $145 per month, potentially for thirty years? I sure would! Your breakeven is just over fifteen months, and most folks keep the loan significantly longer than that! Every month you keep the loan over 15, you're $144.57 further ahead of where you would have been without refinancing.

At 5.875%, the loan costs half a point now. Your new loan balance would be $309,346.73 and change, which in the real world gets rounded to $309,350 and putting the difference of $3 plus loose change back into your pocket somehow, but I'm going to deal with the non-rounded number. You paid $4346.73 to get that loan done, and your monthly cost of interest goes to $1514.51. You're saving $197.99 per month, but you spent about twice as much to make it happen. Breakeven is not quite 22 months as opposed to your current situation, but longer than that as opposed to the competing loan, which is over $1000 to the good by the time this loan breaks even. Indeed, this loan won't catch its 6.125 competitor for 44 months or thereabouts. In the absence of other choices, I'd be willing to spend this money for this benefit for myself, but over three and a half years is a longer than median time to refinance. I'd rather have the 6.125 loan in this instance. You will get more benefit out of this loan in the long term if you keep it, but most people won't keep it long enough.

At 5.625%, this loan now costs one full point, and your new balance would be $310,909.09. Like it or not, you spent $5909 to get that loan. Your monthly cost of interest drops to $1457.39, saving you $255.11 per month. Breakeven: A little over 23 months. Everything that I said before about the 5.875% loan is also true for this one, except that because the monthly benefit is larger, it catches the 6.125 loan that is your best alternative thus far faster - a little over another ten months, or between 33 and 34 months until it's the best alternative thus far, and once it's in first place, it pulls away from the others quickly.

At 5.375%, this loan now costs two full points, and your new balance would be $314,081.63 if you chose it. You spent $9081.63 to get it, while your monthly cost of interest drops to $1406.82, saving you $305.68 per month. You break even after 29.7 months. If it were the only alternative other than "do nothing", I'd still be willing to do this for myself, but since it takes longer to catch up to some of its competitors, it wouldn't be my first choice from among the presented options. Mind you, if you kept it for the full 30 years, it would be the best possible alternative, but most folks don't keep their loan even three years, let along thirty. By the time this has broken even, the 5.625% loan is about seventeen hundred dollars to the good, and at $50.57 per month lower interest, you're looking at over 32 more months until this is the best alternative. 62 months is over five years. I'd rather do 5.625 for me in most circumstances, thank you very much.

Circumstances alter cases. If you have some knowledge about the future of the situation, any of these can be the best possible loan. For instance, if you know you're going to have to move and sell in two years, or if you're retiring (but staying put!) and it's going to be difficult to get loans from here on out, those would each alter which decision I'd recommend. If loan rates are expected to continue declining or even to be volatile in about this range, I'd choose a cheaper alternative trying to get as close to a True zero cost loan, while if all the top analysts are saying that rates aren't going to be this low for another ten years, I'd strongly consider paying the points to get the low rate.

There is more to the decision of refinancing than just rates, and choosing a mortgage loan by payment is one of the best ways I know of to waste large amounts of money. Unless rates nose-dive even further than this, like they did in 2003 (It sure was nice telling people I could get them 5.375% for literally zero cost when most of them were around 7%), for most people there probably isn't a choice that both saves you money and has you ahead of the game right away - and even so, that may not be the best choice in your situation. Calling loan officers to demand "What's your lowest rate?" isn't going to help anyone - especially not you. You need to have some good conversations with several loan officers

Caveat Emptor