The 8 Secrets of Refinancing Mortgage Loans
What’s secret depends on your perspective. At Bills.com, we talk to and exchange e-mail with people interested in refinancing their home mortgages daily. The secrets we reveal to readers are not in the Wikileaks-class of confidential communiques that would shock an experienced loan officer. Instead, these are overlooked facts about mortgage refinances that consumers either never learned or overlooked.
1. Not Shopping
Pretend for a moment that you want to buy a car. Do you buy from the first dealer you find? Perhaps, but more likely you will try several dealers and educate yourself by visiting the Kelly Blue Book Web site, CARFAX, and Craigslist to get an idea of market prices. Mortgage shopping is no different from buying a car. The quote you get from a loan officer might be competitive, or maybe not. How will you know unless you shop around?
2. Waiting for Lower Rates
Predicting mortgage interest rates is a bad idea. When the US government stopped funding mortgages in the summer of 2010, everyone predicted rates would rise. They were wrong. Rates fell to their lowest level in generations. As 2011 begins, mortgage rates have begun to rise, but who knows if this is a temporary blip or the start of a long-term trend.
Think of interest rates this way: Rates go up and down, but time goes in one direction. If you refinance today and mortgage rates drop to near-zero next year, you can always refinance then. However, if rates jump to 10% you cannot go back in time to refinance when rates were lower.
If your rate is higher than the current rate, do the math to determine your break-even point. Generally speaking, if you plan to live in your home for the foreseeable future, then refinancing is a good idea. If you plan to move in the next three to five years (unless your present rate is stratospheric), then a refinance may not make sense economically.
3. The Big Four
Step back a moment and consider your financial situation from a mortgage lender's perspective. A bank wants four things from a perfect borrower:
- Stable income — Two years at your employer in the same industry.
- Good recent credit history — Fannie Mae-conformant loans require a 620 FICO score
- Low debt-to-income ratio — Fannie Mae conforming loans require 45% or less
- Equity in the property (or for a home purchase, a down payment)
Download a Uniform Residential Loan Application (Form 1003) and look at your application dispassionately. Do you offer all four elements? If you see holes in your application, your loan officer will, too.
4. Watch the Term
Fifteen- and 30-year mortgages are the most common types of fixed-rate mortgages, although different terms, such as 20-year terms, are available. When reviewing a proposed mortgage refinance, pay particular attention to the length of the loan. For example, if you are 10 years into a 30-year mortgage, you may receive a refinance proposal for a 30-year loan. Such a proposal may offer a tempting payment decrease. However, a longer term will increase the life-time cost of a mortgage. In effect, refinancing a 30-year mortgage that is 10 years old with a new 30-year mortgage makes the effective length of the mortgage 40 years.
If you absolutely need to cut your monthly payment, then chose a 30-year loan. However, if you can afford a slightly higher payment, pick a 15- or 20-year loan. Your rate will likely be lower than a 30-year loan, which will make the difference in monthly payments less than you may expect.
5. Interest Rate Is Not Everything (Fixed vs Variable)
Loans can have a fixed or a variable interest rate. Fixed-rate loans have the same principal and interest payments thought the life of the loan.
Variable-rate loans can have any one of a number of indexes and margins that determine how and when the rate and payment amount change. If you apply for a variable rate loan, also known as an adjustable rate mortgage (ARM), a disclosure and booklet required by the Truth in Lending Act describe the ARM. Most loans can be repaid over a term of 30 years or less. Most loans have equal monthly payments. The amounts can change from time to time on an ARM depending on changes in the interest rate. Some loans have short terms and a large final payment called a balloon.
Today, ARMs have much lower rates than fixed-rate loans. However, it is likely that interest rates will not stay at their historically low levels, and will rise. For example, Fannie Mae, which has a large influence on the market, requires that all ARM borrowers must qualify at their initial ARM rate plus 2%. Fannie Mae expects today’s ARM to reset at a rate 2% higher than they are today, and so should you.
6. Fees & Points Explained
The price of a home mortgage loan is stated in terms of an interest rate, points, and other fees. A point is a fee that equals 1 percent of the loan amount. Points are usually paid to the lender, mortgage broker, or both, at the settlement or upon the completion of the escrow. The borrower can pay fewer points in exchange for a higher interest rate or more points for a lower rate.
The Truth in Lending Disclosure Statement will show you the Annual Percentage Rate (APR) and other payment information for the loan you have applied for. The APR takes into account the interest rate, but also the points, mortgage broker fees and other fees that you have to pay. Ask for the APR before you apply, and ask if your loan will have a prepayment penalty for paying all or part of the loan before payment is due. You may be able to negotiate the terms of the prepayment penalty.
Comparing APRs is one effective way to compare loans, but it is not complete. You also need to compare the up-front points and other fees. However, keep in mind that points can usually be deducted for the tax year you purchase a home.
7. When It Is A Bad Idea to Refinance
There are three situations where it does not make financial sense to refinance:
A. Your mortgage is old
In a mortgage, the proportion of a payment credited to the principal of the loan increases each year, while the proportion credited to the interest decreases. Therefore, in the later years of a mortgage, more of a payment applies to principal and helps build equity. By refinancing late in a mortgage, you will restart the amortization process, and most of your monthly payment will be credited to paying interest again and not to building equity.
However, if you refinance to a lower rate and a shorter term, the interest expense may still be in your favor.
B. Your current mortgage has a prepayment penalty
A prepayment penalty is a fee that lenders may charge if you pay off your mortgage loan early, including for refinancing. If you refinance with the same lender, ask whether the prepayment penalty can be waived. Consider the costs of any prepayment penalty against the savings you expect to gain from refinancing. Paying a prepayment penalty will increase the time it will take to break even, when you account for the costs of the refinance and the monthly savings you expect to gain.
C. You plan to move or sell your home in the next few years
The monthly savings gained from lower monthly payments may not exceed the costs of refinancing. Consider an adjustable rate mortgage, if you are confident that you will not remain in your house for an extended time, doing the math to see if refinancing makes sense.
8. No-Cost Refinances are Not Free
Lenders often define “no-cost” refinancing differently, so be sure to ask about the specific terms offered by each lender. Basically, there are two ways to avoid paying up-front fees.
The first is an arrangement in which the lender covers the closing costs, but charges you a higher interest rate. You will pay this higher rate for the life of the loan. Ask the lender or broker for a comparison of the up-front costs, principal, rate, and payments with and without this rate trade-off.
The second is when refinancing fees are included in (“rolled into” or “financed into”) your loan — they become part of the principal you borrow. Although you will not be required to pay cash up front, you will instead end up repaying these fees with interest over the life of your loan. When lenders offer a “no-cost” loan, they may include a prepayment penalty to discourage you from refinancing within the first few years of the loan. Ask the lender offering a no-cost loan to explain all the fees and penalties before you agree to these terms.
If you do not plan to sell or refinance in three to five years and your closing costs are less than the additional interest, more than likely they will be, then it is worth it to pay the closing costs up front. Even factoring in your tax deduction, paying the closing costs would still save you money over the long-term. The higher your mortgage balance, the more that extra quarter point will cost you.