Changing Rates and Streamline Refinancing - Reasons to Love Zero Cost Loans and Hybrid ARMs

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(NOTE: AT this update, laws exist enacted in the latter part of the previous congressional session that essentially outlaw zero cost and low cost loans by outlawing yield spread. If you can't make yield spread, you can't use yield spread to cover loan costs, and you can't do a low (or zero!) cost loan. We should all thank Barney Frank by voting for his opponent in every election, or making a campaign contribution if you don't live in the district. His blanket hatred of brokers is irrational, and has caused many adverse consequences for consumers of which this is only one. Nonetheless, it is possible that the new Congress might do something to fix this)

Rates move up and down constantly. This is one of the strongest reasons both Intelligent consumers and intelligent loan officers love zero cost loans. Every time rates drop, I call or send an e-mail to those clients who signed up for low cost loans since the last time rates dropped this low, and voila, I'm saving them money for basically nothing. They got a low cost loan to start with, and on the refinance they're getting the same rate as someone who paid multiple points at the same time they got their current loan - for nothing extra.

A streamline refinance is a refinance where there is no cash out by Fannie and Freddie's definition. The rate must be lower, the payment must be lower, and the equity situation must qualify for at least the same program the borrowers had last time. If you roll the expenses into the balance cannot be higher than what was approved last time. Most streamline refinances are with the same lender, but there are a very few lenders who will or have in the past allowed streamline refinancing of another lender's loan.

Here's how and why it works. There is always a tradeoff between rate and cost. Rates had increased notably in the month prior to originally writing this, but that's good fodder for an example. I'm going to assume a $400,000 current loan. Closing costs on that loan were $2815 including appraisal, escrow, and title insurance. Usually, appraisals are not required for streamline refinances, but right now, lenders are in panic mode, so they are. Those who have the gold make the rules for lending it out. The A paper rates for the day I originally wrote this were a thirty year fixed rate loan at 5.875% for two points, 6.25 for one point (actually about 3 tenths), or 6.375 for zero points. Here's a table listing new rate, new balance, monthly interest cost, and how long it takes to recover the cost for the loan via lowered cost of interest in months as opposed to the 6.75% loan that I can do for no cost to the borrower at all.

New Balance

Now once you've paid those costs, they're sunk into the loan. Furthermore, your rate is locked into concrete. Just because better rates come along does not mean the lender is automatically going to lower your rate, any more than they can raise it if rates go up. That Note is a binding contract on both sides. So if you want to refinance before you've broken even, any money you haven't recovered yet is just gone. The alternative is not to refinance at all, and keep your old loan, horrible though it may be by the standards of a later time. And if you do want to refinance again, it doesn't matter what your current rate is - you're going through the entire qualification process anew, and you have to pay closing costs again as well as, if you want them, discount points to buy the rate down.

Let's say it's a year from today, and rates drop to where they were a month previous. 5.25 for two points, 5.5 for one, 5.75 for zero points, and 6 percent even for zero cost. Let me stress for the hard of understanding who may be reading this that this is a purely hypothetical supposition. Depending upon the loan you chose today, here's your situation in twelve months:


At our hypothetical rates one year from now, the person who chose 5.875% initially cannot be helped without spending some money. In fact, I can move anyone who chose a loan costing one point or less down to a rate almost as good as what they spent $11,000 to get for absolutely zero cost. So their balances stay exactly the same, and here's the new situation

Orig Rate
New Rate

Notice that the person who chose that zero cost loan in the first place has a monthly cost of interest that's $8 to $17 lower than anyone else - and he owes thousands of dollars less on his loan! The people who spent money buying the rate down will literally never catch up to him! Even though the interest for the guy who keeps the initial 5.875% interest rate is a little lower, with thousands of dollars difference on the balance, you're still talking fifteen years or so for him to break even with the people who initially spent less to buy the rate down, straight line computation, never mind time value of money!

This isn't magic, and it isn't totally hypothetical. This is almost predictable. A few years ago the median age of mortgages was down to sixteen months. I can't seem to find it in the current Statistical Abstract, but I've heard it's all the way up to 28 months - still less time than it takes to break even for the costs of the expensive loan above, and pretty much the same as the break even for the loans where you spent some money to get the loan. Why in the name of whatever divinity you worship would you want to spend money that most people are never going to get back?

Considering this information, there's another loan that actually makes even more sense for most folks - a hybrid ARM. This is a thirty year loan with an interest rate that is initially fixed by the loan contract for a certain number of years, after which it will become an adjustable rate mortgage. For about 15 years, I've been doing 5/1 ARMs for myself. Even when the rates on thirty year fixed rate loans were ten percent, I've always been able to get a 5/1 ARM around six percent or less. For a couple of years, the rates on 5/1 ARMs were essentially the same as for thirty year fixed rate loans - meaning there was no real reason not to buy thirty years of insurance that your rate wouldn't change. Why not, when it's been cheaper than 5 years worth of the same insurance? But ARMs are now diverging significantly below the rate/cost tradeoff of thirty year fixed rate loans, so now we're getting back to the normal situation, where people willing to relax just a little bit on a mental requirement for a thirty year fixed rate loan can reap substantial rewards. A month before I originally wrote this, a 5/1 ARM at zero cost was at 5.75%. Despite 30 year fixed rates skyrocketing, the 5/1 when I originally wrote this was around 6.125. So for the same zero cost of a 6.75% thirty year fixed rate loan, you can get a five years of fixed rate at 6.125% then - and move you down below 5% at this update. On a $400,000 loan, this saved you $2500 per year when I originally wrote this - more than a full month of interest on the thirty year fixed rate loan. At the update, you save more than $5000 per year more. Furthermore, we've already covered the fact that the vast majority of people aren't going to keep their loan long enough for a 5/1 ARM to turn adjustable anyway. If you're among those 95% of all real estate borrowers who aren't going to keep the loan five years, there isn't any practical difference between a thirty year fixed rate loan and a 5/1 ARM except that you pay five eighths of a percent less interest - slightly over $200 per month saved in this instance. You can pay the same as a thirty year fixed rate loan and apply the interest savings to principal - which means you'll owe $14,000 less at the end of five years, assuming you keep it that long, and that rates don't drop so you can refinance at a lower rate, again for free. Another alternative is that you can invest the difference, in which case you'll have over $15,000 extra in an investment account, assuming an average 10% return per year. Who cares if you then need to spend $3000 of it refinancing if the rates never get this low in that period? Okay, I care, but since I'm still $11,000 or so ahead after I spend it, if I need to spend it, that is one heck of a good investment!

Some people prefer other ARMs. I see people encouraging the 10/1 and 7/1 for people who think the 5/1 isn't long enough. And if you're one of those folks who is going to lie awake every night for five years because you don't have a thirty year fixed rate loan, the difference between a 5/1 ARM and a thirty year fixed rate loan makes a difference of about $6 interest per night. Split two ways, for you and your significant other, that's $3 each for a good night's sleep. A good night's sleep is worth $3 to me, it's worth $3 for my wife, and I presume your sleep worth $3 per night to you, also. There's nothing explicitly wrong with choosing a 7/1 or a 10/1 as opposed to a 5/1, either. It's mostly a mental comfort issue. Most folks don't keep their loans 5 years anyway, so if I'm one of that huge majority of homeowners, why would I want to buy seven or ten years worth of insurance that my rate won't change? The only answer that makes any sense other than mental comfort is if the rate/cost tradeoff for those loans is cheaper, and that is only rarely the case. At the rates when I originally wrote this, you were giving away three eighths of a percent for the same zero cost loan on a 10/1 basis - 60% of your savings, although the 7/1 was almost exactly the same cost as the 5/1, so that's a good choice. Most folks won't use the two extra years, but if it's essentially free, why not take it in case you do? For the 3/1 ARM, on the other hand, was actually slightly more expensive at the zero cost level we're considering today, and even if it was cheaper, you're getting down closer to average holding period, so perhaps a third of the people who got it might want to hold it longer than the fixed period. Furthermore, I don't think I've ever seen a zero cost 3/1 more than an eighth of a percent lower rate than a 5/1 at the same cost. Let's say you could get one at 6% today for that loan, instead of 6.25. You save $41 extra per month - $241 over the thirty year fixed - but you've only got a maximum of 36 months of savings. $241 times 36 is only $8676, as opposed to $200 times 60 months, which is $12,000, not to mention more ability for compounding to have an effect in the case of the 5/1 ARM, and that the idea is refinancing to a favorable rate before the end of the fixed period. For all of these reasons, I can't really see choosing a 3/1 for any set of circumstances I can remember seeing any time in the last fifteen years or so.

To summarize, rate/cost tradeoffs between loans go up and down constantly - the rates for A paper change every business day, at a minimum. Nobody can predict exactly when they will rise or drop again, but that they will vary over a given range is pretty much axiomatic. Furthermore, there is always a tradeoff between rate and cost for any given loan type at any time, and if you choose a loan with low rates for that time but comparatively high costs, it will be years before you have recovered your initial investment via cost of interest. Since by that point it is very probable that rates will have fallen below today's rates at least temporarily, and you will have wanted to refinance, this is only rarely a good investment. A better way to cut your cost of interest is to choose a hybrid ARM with a fixed period likely to cover the period of time you will keep a given loan in effect.

Caveat Emptor

Original article here


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This page contains a single entry by Dan Melson published on May 21, 2014 7:00 AM.

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