Refinancing - should I - or not?

I'm getting lots of questions regarding refinancing - on personal residences and investment property (rentals and commercial) - and it's such an important topic - something we really need to look at and explore - so let's do that.

There are several reasons people don't refinance - one of the most common is a lack of understanding of the process and how they might fit in to that process and being afraid of the complexities.

But, first, in some cases, realistically, it just won't work. Some of those reasons would be

 - Unemployed (without any other source of income)

 - Seriously underwater on the mortgage - you owe a lot more than what your house is worth (still may be some options)

 - Bad Credit

Unemployed

If you're unemployed - it doesn't matter that you always pay your bills - I hear that a lot. From a lender's perspective - you have no way of paying back the loan. For the most part this is going to be a no starter. I'm sorry, I didn't create the economic mess - but trouble or not - this is usually a no go on the process. You need to show steady income.

Note that 'income' doesn't have to be from wages - if you get money from investments; Social Security; Rentals; Trusts; Contract Sales on property (Real Estate, Land, Airplanes), business sales and the like - well, you do have income. You would qualify - assuming everything else was ok. You don't need a 'job'.

Underwater

Being seriously underwater on your mortgage can also be a deal killer, but let's look at some options on that when we look at the process. Depending on your situation - this is ok, it may still make super great sense to refinance. We'll explore this later.

Bad Credit

A serious deal killer. I explain over and over to clients how significant this factor is and they will often say - oh, I've got great credit - yet their scores are actually quite low. Maybe not low enough to disqualify them, but low enough to where it will cost them tens of thousands of dollars. Pay attention people! We'll cover this more later too.

If you have a really low credit score you'll have a lot of work to do. Honestly, if you've got a loan, you'll probably have to stick with it until you can improve your credit.

If your credit rating is bad from the economy, for medical bills - that type of thing - I'm super sympathetic to you. If it's because you've just not paid much attention to it - and let bills get missed - well, we need to work on you - most of the time it's just being more organized.

Review your situation

Because of the constantly changing nature of terms for refinancing - we'll work on big picture - concept issues.

1. Generally, you want to be able to save about .50% (less than 1%) or more on your mortgage.

So, if your mortgage is at 6% and the rates are now 4% - well, you need to move fast - a great candidate. If your rate is 8% and they are now 4% - well, what's the problem? Have you been in a deep sleep?

Conversely, let's say your rate is 5% and you can get 4.25% - should you refinance? Most likely yes.

The general rule would be that if you can save 2% on your rate - you'll pay back the loan fees in 1 year. If you can save 1% on your rate, it will take you about 2 years to pay back the loan fees.

Again, conversely, let's say you can save 3% - well, at that you'll recover your fees in about 6 months. Save 4% - you'll recover your fees in about 3 months. See how that works?

So, look at the rate difference and use the above general rules to determine how long your recovery period would be. If it's 2 years, and you're going to live there another 10 year or even another 3 years - basically more than 2 years - then - yes, it would be worth the effort to refinance.

2. Property valuation

Getting a value

If it's a personal residence, you'll generally need a 5% difference between your mortgage and your property's value. For investment property you'll generally need about a 20% difference.

So, a home is valued from an appraisal - and there isn't a big mystery to that. Someone physically compares your house to nearby ones that have sold recently. Since obviously, two houses aren't the same - he or she makes judgments on what an extra bedroom or a view is worth.

I remember when the website Zillow was launched - and I have no connection to them in any way other than both being in the same city - but anyway, when it was launched I laughed because the whole premise seemed so ridiculous. In case you don't know, it's a free online site that 'values' every property in the US as far as I know - maybe even further.

In the beginning, Bill Gates' house - who lives here in Seattle - they had it valued at a ridiculous number. I think he put like $130 million into it - and that was when $130 million meant something - ha ha.

As you can imagine, it probably wouldn't fit a normal valuation algorithm. So, that got them off to a bad start, but they quickly recovered, and honestly, they do a pretty good job now. I'm pretty impressed.

For the most part, you can get a good valuation from their site. If your property has some really unique things - like views - lakes - whatever - well, yeah, that might not be counted. They give a range and so that should give you an idea.

There are other ways I'm sure, but Zillow is free and a good place to start.

After determining your value and mortgage balance

Ok, so somehow you've got an idea of your property value. So, let's look at the difference. So, if your property value is $300,000 and your loan balance is $285,000 or less (95% of the value) - you're good to go. If you have investment property and the value is $300,000 then your mortgage is $240,000 or less (80% of the value) then you too are good to go.

If your loan percentage is at or less than these thresholds then you are a great candidate for a refinance and should be looking at doing that.

Now, let's say your home property is valued at $300,000 and your loan is $295,000 ($10,000 over the limit of $285,000 or 95%). Let's further say your current rate is 6% and you can get 4%.

Well, wow - let me tell you - I'd be trying to find a way to come up with $10,000 to refinance. The 2% difference in the rate would save me about $475 a month in this example. Yes, $475 a month - ($285,000 * .02 / 12 months = $475).

And think about it - the $10,000 you'd pay to refinance - it's not like you're giving that money away as a fee - you are paying down your own loan. So, now instead of owing $295,000 - you owe $285,000 'and' and and - you are saving 2% in interest!! Are you kidding - it's a no brainer!

But - of course you have to have $10,000 in that example. So, you really have to look at your situation - the point is - if you have money in the bank and can do a pay down on your mortgage without cutting it too close - well, it may make a lot of sense. A 'lot' of sense. What creative things can you do to make that happen? Try and think outside the box.

The Actual Interest Rate

While you do need to shop around a bit for the best rate and fees - your credit score can play a huge difference in what you pay. Someone with a near perfect score may get say a 4% loan where someone with a weaker score 4.75% and the lowest and still qualify might be 5.5%.

On a $300,000 loan the weaker score pays $187.50 more a month and the one with the lowest credit score pays $375 a month. That's $2,250 and $4,500 a year respectively. I don't even want to multiply that over 30 years. Oh, my. I think I could find some other use for that money.

So, obviously, you want to have the best credit score possible. And as I've said before, if it's from the economy or health things - I'm sorry - otherwise - what the heck are you thinking. Get your act together - seriously. You're destined for a life of financial insecurity unless you get that under control.

 Honestly, most of the disasters I see in people's finances is self generated. Everyone has ups and downs and as I said, I'm sorry for those in that situation. But, refusing to be involved in your own finances - burying your head in the sand - totally relying on someone else - is - well, consider yourself smacked upside the head. If you don't understand something - ask questions until you do.

The Process

Ok, everything else checks out - enough of a difference in the interest rate, credit ok, appraisal ok - so should I do it? Well, why in the world would you not? Too hard? Seriously? Go back and reread this sentence until you think - yes!

Sure, it's a little work but to get the kind of savings you can get - once you do it you'll be saving money every month. Pretty much you'll just spend time filling out some forms and making copies of bank statements - things like that. Honestly, there isn't that much work for you to do - but do it you must and don't dilly dally either - just do it and get the process going. Your bank or mortgage broker will do most of the work.

Fees

 Common fees would be a Title Report - showing there are only disclosed loans on the property. This runs from about $300 - $1,000. You'll also have an Escrow fee - which is a charge for who handles the actual paperwork and filings. It's typically $250 - $750. Additionally, you'll also have a couple of hundred dollars in miscellaneous fees like credit reports and filing fees and appraisal costs.

The biggest fee is typically a 'loan fee' or 'origination fee' - it can come in many names but conceptually, it's a one time fee for borrowing the money. So, if your loan amount is $280,000 and your loan fee is 1% then your one time loan fee is going to be $2,800. Loan fees vary from no loan fee to perhaps 1.5% or so. Obviously, the lower this is the less time it will take you to recover the fees.

A loan may also offer the opportunity to 'buy down' the rate. So, they may offer you 4.5% or 4.0% with a buy down cost of .375% of the loan. So, if your loan is $300,000 then the buy down cost would be $1,125 ($300,000 * .00375). Basically the way to look at this is will you live there long enough to recover that extra fee. In my example that buy down of $1,125 would be made up in less than a year. $300,000 * .005 rate savings = $1,500 a year. Your cost was $1,125 - so in this example - probably obviously yes - makes sense.

So, there are your biggest fees - Origination or Loan fees, Title Report and Escrow fee. Compare those fees to your monthly interest rate savings to see how long of a recovery you have. Generally the rules stated earlier will apply. Do the buy down calculation separate.

Now, a lot of people want to count in Insurance and Tax reserves as part of the cost and that just isn't the case. They are only collecting an estimate of the costs - if your present loan is collecting for these - you'll get that money back. Don't confuse the issue.

Interest adjustment - same thing - that's not really a loan cost - if you look, you'll end up skipping a payment so this should wash out for you as a no cost - except your new payment will be less because your rate is lower.

Common statements I've heard

I'm not going to be saving that amount every month. Your minimum payment difference is a permanent decline in a fixed rate situation as described here. The amount of actual interest you save true - it won't stay the same, because the balance will be going down and so the amount you save will decline as the loan is paid down. So what? Your savings over the loan period is tremendous. What you want is to recover your fees and the rest is gravy. Plus you have a permanent - up to 30 year - reduction in your rate.

I'm starting over on the 30 years.

Well, that's true, and you'll actually have a change in your payments from two angles - one is your actual true interest rate savings that I've based all this on and two from the extending of your payment out to 30 years or your new loan term.

I like to have the 'minimum' I have to pay on something be as low as possible. So, by setting the payments so low - if I have some issues such as a drop in income - my minimum payments will be a lot less.

Depending on your age and situation - do you really care that it's now 30 years? In a lot of cases, I'm not sure it really matters - the client isn't going anywhere - they have steady but not climbing income - well, yes, they have extra cash flow - so that's going to be great for them.

If your desire is to have your home paid for - well, a worthy goal, but look at the overall. Is it to leave more to your child who won't return your phone calls unless they need something? Ha ha. Seriously, don't let emotion work your decisions. Make good logical choices for you.

The simplest solution though and the smartest would be to continue making the same payments you are used to making now and you'll have a pretty good excess coming off the principal each month. That loan balance will reduce at a phenomenal rate - except it's really not phenomenal because we can explain it.

But consider if you want to do that - look at your age - income future - present situation to decide.

But, the bottom line is that if you can do it you'll save money if you can refinance. Of course if it's not in the cards there's nothing you can do - but there are still a lot of people I've seen that could do it and could benefit a lot and just haven't. It might take being creative, but it's up to you - pay more money if you want - personally I'd rather have more to spend on the things I really want.

Take some charge of your finances. You'll feel better about it.

Joe Poff, CPA

The Real Estate market has been and will continue to be a highly leveraged commodity. Sure, right now it's in the dumps - hardly anyone can get loans - those that can are too afraid. But there are signs it's already easing. For example, appraisals now must be made by those familiar in the area - there are issues about whether foreclosed properties should be in samples. Applications are becoming less restrictive too - ever so slightly but they seem to be easing. Credit score minimums have also been lowered.

The near or at 100% financing we had enabled a lot of people to buy property - residential and commercial alike who otherwise may not have been able to do so. Under some circumstances that 'can' and 'does' work - but you can't just blindly do it - you need to really look at the situation. Something that wasn't happening in the industry just prior to the collapse. But with or without the 100% financing 70-98% was common place and most of the time worked and still will work. It will be common place again.

In business you make money by leveraging yourself by your employees (or perhaps by machines). If you never had employees a business would have difficulty in growing or surviving.  It's the same in Real Estate - many clients of mine bought their own buildings to house their business in highly leveraged loans. It was rare when they didn't work out. Everyone won in those - my client was in better shape than renting - the bank did fine - things were great.

The concept of cheater intro interest loans, negative amortizations, the borrowers 'pretending' they didn't understand and the borrowers that really didn't understand - no wonder the Real Estate market had what the stock market calls a major correction. But we will go back to the heavily leveraged loans - it just has to happen. Along the way - Real Estate values will go up.

The market is still in a state of flux but smart - nerves of steel investors could make some money by buying some Real Estate. While prices might still drop - say another 10% if you buy now - the likelihood is that would be the extreme and we are probably at or near the bottom now. Signs of stabilization are showing up - not great - but stabilization. Also, pressure will be on our elected officials as the election season starts.

So, depending on your cash situation and investment strategy you might want to investigate the availability and pricing of some properties be that commercial, residential or land - all depending on your personal situation.

Be smart - don't over commit either physically, mentally as well as financially. Real estate transactions can be stressful but the more of them you do the easier it becomes. If you're planning on developing a property - well that's a lot of work - research it first - know what you are doing. If you want to be a landlord be prepared for it being vacant and the dead beats that leave your rental house in shambles. On the positive side - don't look for a quick return, but given time you will come out ok. Just think of the population increases - mathematically, they will have to increase in value.

As an alternative to investing directly into a project you could invest in a mutual fund or similar type investment that specializes in Real Estate projects.

Joseph E Poff, CPA

In the years – decades really – that it took me to design and develop the financial game Economics 411 ( http://www.Economics411.com ) – I often thought of enhancements I wanted to add. One was a Blog that brought together many different authors - all interested in the Economy and in Investing. Each would write a little bit about their knowledge and experience on these topics.

For example, as a CPA, I’ll have topics that relate to my experiences and my clients in the accounting finance area as well as Information Technology. A Stock Broker, Real Estate Agent, Mortgage Broker or fellow CPA will be viewing things from a different angle and their topics will undoubtedly be different than mine.

One thing my 30 years in public practice taught me is that some of the keenest insight of investments and businesses came from clients that weren't in the financial - accounting industry. So, while we’ll have professionals as authors I'd also like to encourage others that want to share their insights with others to participate.

Let me know if you'd like to become a contributor on this site. We already have several people that will be coming on board shortly.You can leave comments and rate any story you read here and then check back to see what responses you generated.

If you have Questions – you can submit them too for our anonymous Q&A page. You can also contact any of the Authors directly for a personal answer, but keep in mind that they often only have their time to sell and so if you are taking up some of their time you should expect to pay them for their time. I’m sure any of them would be more than happy to consider taking you on as a client.

It took a long time to get Economics 411 up and running and I'm sure this will take some time too. I'm excited as The Blogs of Economics 411 has finally launched – roughly a year after Economics 411 launched.

I think there could be some great practical posts for people to read and hopefully help them with their own personal finances. Perhaps in 20 years, someone that has read some of the articles on The Blogs of Economics 411 and played Economics 411 - perhaps they'll have a little more money that they would have if they passed us by - who knows - I'm going to think so! 

Joseph E Poff, CPA