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Refinancing - should I - or not?
Posted by: Joseph E Poff, CPA CITP from Auburn Software, Inc. on Monday January 16, 2012 at 3:58 PM   (-08 GMT) | Comments (4)
Tags | Loans, | Mortgages, | Real Estate | Categories: | Real Estate - Apartments, | Real Estate - Commercial Building, | Debt - Home Mortgage, | Real Estate - Personal Residence

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

 

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Comments

Posted by Ifeanyi from United States posted at Monday, March 26, 2012 21:13
Comment from Ifeanyi is -
It makes perfect sense. Here's why: Your credit score is only part of the equation. They also look at the amount of credit you have available vs. what you owe. In other words, if you have three credit cards, each with a $10,000 limit, it doesn't matter that you've never used them and they have a zero balance. Creditors look at that as you have a potential to have $30,000 in debt and that's less money you'll have to pay them back. But if you have three credit cards, one with a $1000 limit and zero balance, two each with $500 limit and damn near maxed out, that somehow works better for you because they see you only have $2000 in other obligations, and unless you're jobless, they'll get their money from you. The other part they look at is the age of the items on your credit report. Less than three years is like being brand new in many cases. They see it as they don't know you well enough type of thing. That's why, if you EVER have to cancel a credit card, try not to cancel the older ones, cancel the newest one. Longevity is good.
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Posted by Sabrina from United States posted at Monday, March 26, 2012 14:49
Comment from Sabrina is -
Hey! Your blog popped up on bing and I checked out some more of your stuff. I just added you to my Google Reader feed. Keep it up. Look forward to reading more from you in the future.
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Posted by Ram from United States posted at Monday, March 26, 2012 06:31
Comment from Ram is -
You may not want to hear this, but your perception of what a reasonable rate is and what your lender thinks is a reasonable rate are completely different. While you are looking at your rate for your 20% loan and comparing it to your first, your lender is pricing your second mortgage to adjust for the increased risk of lending out 100% of the value of your home. If you are looking to replace your current second mortgage, understand that there are no real deals out there for stand-alone second mortgages and there are not very many lenders (especially now) that offer stand-alones. Your best bet would be to look at a HELOC (Home Equity Line of Credit) to pay off your second mortgage which would be priced at the Prime Rate plus or minus up to one percent and would have minimal or no closing costs. If it makes you feel better though, you are still not in a bad loan structure considering the blended rate that you currently have of 6.05% (5.25*.8 + 9.25*.2) which is not currently available for 80% financing let alone 100%. Also you should be looking at a worst case blended rate of around 6.65% based off of what I am assuming is a 6% lifetime cap on your second mortgage adjustments.
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Posted by Shuuzou from United States posted at Sunday, March 25, 2012 02:48
Comment from Shuuzou is -
There are some factors to consider here. First, in today's world, who stays in one spot so long? On top of that, who wants to be paying a mortgage when you are retired? Many people today can't afford to live on their retirement and you want to add a mortgage payment to that? Second, with the way mortgages work, you the bulk of the interest up front. Lets take an example: Say you borrowed $ 300,000 for a home at 6% interest for 30 years. Your payment is around $ 1800.00 per month. You don't get 10% of the loan paid off until year 7. You get to 20% of the loan paid off in year 12. The total interest you pay the bank over the whole lifetime of the loan is $ 347,514.00.If you take the same thing and do a 40 year mortgage your payment per month is $ 1650.00. You get to 10% paid off in year 12. You get to 20% paid off in year 19. The total interest you pay the bank is $ 492,307.20. For a 50 year mortgage your payment per month is $ 1580.00. You get 10% of the loan paid off in year 18 and 20% of the loan paid off in year 27. The total interest paid to the bank is $ 647,526.00You can see that going longer is not the smarter thing to do. If you need to have a 40 or 50 year mortgage to afford your home then you need to look at a cheaper home.
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