The most common reason for refinancing is to save money. Saving
money through refinancing can be achieved in two ways:
- By obtaining a lower interest rate that
causes one's monthly mortgage payment to be reduced.
- By reducing the term of the loan,
thus saving money over the life of the loan. For example,
refinancing from a 30-year loan to a 15-year loan might
result in higher monthly payments, but the total of the
payments made during the life of the loan can be reduced
significantly.
|
People also refinance to convert their adjustable
loan to a fixed loan. The main reason behind this type of refinance
is to obtain the stability and the security of a fixed loan. Fixed
loans are very popular when interest rates are low, whereas adjustable
loans tend to be more popular when rates are higher. When rates
are low, homeowners refinance to lock in low rates. When rates are
high, homeowners prefer adjustable loans to obtain lower payments.
A third reason why homeowners refinance is to consolidate debts
and replace high-interest loans with a low-rate mortgage. The loans
being consolidated may include second mortgages, credit lines, student
loans, credit cards, etc. In many cases, debt consolidation results
in tax savings, since consumers loans are not tax deductible, while
a mortgage loan is tax deductible.
The answer to the question "Should I refinance?" is a
complex one, since every situation is different and no two homeowners
are in the exact same situation. Even the conventional wisdom of
refinancing only when you can save 2% on your mortgage is not really
true. If you are refinancing to save money on your monthly payments,
the following calculation is more appropriate than the rule of 2%:
- Calculate the total cost of the refinance––example:
$2,000
- Calculate the monthly savings––example: $100/month
- Divide the result in 1 by the result in 2––in
this case 2000/100 = 20 months. This shows the break-even
time. If you plan to live in the house for longer than this
period of time, it makes sense to refinance.
|
Sometimes, you do not have a choice––you are forced
to refinance. This happens when you have a loan with a balloon provision,
but with no conversion option. In this case it is best to refinance
a few months before the balloon comes due.
Whatever you choose to do, consulting with a seasoned mortgage professional
can often save you time and money. Make a few phone calls, check
out a few web sites, crunch on a few calculators and spend some
time to understand the options available to you.
The best way to decide whether you should pay points or not is to
perform a break-even analysis. This is done as follows:
- Calculate the cost of the points. Example: 2 points on
a $100,000 loan is $2,000.
- Calculate the monthly savings on the loan as a result
of obtaining a lower interest rate. Example: $50 per month
- Divide the cost of the points by the monthly savings to
come up with the number of months to break even. In the
above example, this number is 40 months. If you plan to
keep the house for longer than the break-even number of
months, then it makes sense to pay points; otherwise it
does not.
- The above calculation does not take into account the tax
advantages of points. When you are buying a house the points
you pay are tax-deductible, so you realize some savings
immediately. On the other hand, when you get a lower payment,
your tax deduction reduces! This makes it a little difficult
to calculate the break-even time taking taxes into account.
In the case of a purchase, taxes definitely reduce the break-even
time. However, in the case of a refinance, the points are
NOT tax-deductible, but have to be amortized over the life
of the loan. This results in few tax benefits or none at
all, so there is little or no effect on the time to break
even.
|
If none of the above makes sense, use this simple
rule of thumb: If you plan to stay in the house for less than 3
years, do not pay points. If you plan to stay in the house for more
than 5 years, pay 1 to 2 points. If you plan to stay in the house
for between 3 and 5 years, it does not make a significant difference
whether you pay points or not!
Zero-Point/Zero-Fee Loans
Whatever happened to the conventional wisdom of waiting for the
rates to drop 2% before refinancing?
You have a 30-year fixed loan at 8.5%. A loan officer calls you
up and says they can refinance you to a rate of 8.0% with no points
and no fees whatsoever.
What a dream come true! No appraisal fees, no title fees and not
even any junk fees! Is this a deal too good to pass up? How can
a bank and broker do this? Doesn't someone have to pay? Whose money
is being used to pay these closing costs?
No––this is not a scam. Thousands of homeowners have
refinanced using a zero-point/zero-fee loan. Some refinanced multiple
times, riding rates all the way down the curve in 1992, 1993 and,
more recently, in 1996. Some homeowners used zero-point/zero-fee
adjustable loans to refinance and get a new teaser rate every year.
The way this works is based on rebate pricing, sometimes also known
as yield-spread pricing, and sometimes known as a service-release
premium. The basic idea is that you pay a higher rate in exchange
for cash up front, which is then used to pay the closing costs.
You will pay a higher monthly payment––so the money
is really coming from future payments that you will make.
You can also think of this as negative points! For example, a 30-year
fixed loan may be available at a retail price of :
8.0% with 2 points or
8.25% with 1 point or
8.5% with 0 points or
8.75% with -1 point or
9% with -2 points
On a $200,000 loan, the loan officer can offer you 8.75% with a
cost of -1 point, which is a $2,000 credit towards your closing
costs. A mortgage broker can use rebate pricing to pay for your
closing costs and keep the balance of the rebate as profit.
The main benefit is that you have no out-of-pocket costs. As a result,
if the rates drop in the future, you could refinance again even
for a small drop in rates. So if you refinanced on the zero-point/zero-fee
loan to get a rate of 8.75% and if the rates drop 1/2%, you can
refinance again to 8.25%. On the other hand, if you refinanced by
paying 1 point and got a rate of 8.25%, it may not make sense to
refinance again. Now, if the rates drop another 1/2%, a zero-point/zero-fee
loan can drop your rate to 7.75%, whereas if you paid points, you
may have to do a break-even analysis to decide if refinancing will
save you money.
The zero-point/zero-fee loan eliminates the need to do a break-even
analysis since there is no up-front expense that needs to be recovered.
It also is a great way to take advantage of falling rates.
Some consumers have used zero-point/zero-fee loans on adjustable
loans to refinance their adjustables every year and pay a very low
teaser rate.
The main disadvantage is that you are paying a higher rate than
you would be paying if you had paid points and closing costs. If
you keep the loan for long enough, you will pay more––since
you have higher mortgage payments. In the scenario where you plan
to stay in the house for more than 5 years, and if rates never drop
for you to refinance, you could wind up paying more money. If, on
the other hand, you plan to stay at a property for just 2-3 years,
there really is no disadvantage of a zero-point/zero-fee loan.
Since you are being paid "cash" up-front in exchange for
a higher rate, it really is your own money that will be paid in
the future through higher payments. Investors who fund these loans
hope that you will keep the loans for long enough to recoup their
up-front investment. If you refinance the loans early, both the
servicer and the investor could lose money.
To summarize, zero-point/zero-fee loans in many cases are good deals.
Make sure, however, that the lender pays for your closing costs
from rebate points and NOT by increasing your loan amount. So if
your old loan amount was $150,000, your new loan amount should also
be $150,000. You may have to come up with some money at closing
for recurring costs (taxes, insurance, and interest), but you would
have to pay for these whether you refinanced or not.
Zero-point/zero-fee loans are especially attractive when rates are
declining or when you plan to sell your house in less than 2-3 years.
Zero-point/zero-fee loans may not be around forever. Lenders have
discussed adding a pre-payment penalty to such loans, however few
lenders have taken steps to implement such a measure.
A FICO score is a credit score developed by Fair Isaac & Co.
Credit scoring is a method of determining the likelihood that credit
users will pay their bills. Fair, Isaac began its pioneering work
with credit scoring in the late 1950s and, since then, scoring has
become widely accepted by lenders as a reliable means of credit
evaluation. A credit score attempts to condense a borrowers credit
history into a single number. Fair, Isaac & Co. and the credit
bureaus do not reveal how these scores are computed. The Federal
Trade Commission has ruled this to be acceptable.
Credit scores are calculated by using scoring models and mathematical
tables that assign points for different pieces of information which
best predict future credit performance. Developing these models
involves studying how thousands, even millions, of people have used
credit. Score-model developers find predictive factors in the data
that have proven to indicate future credit performance. Models can
be developed from different sources of data. Credit-bureau models
are developed from information in consumer credit-bureau reports.
Credit scores analyze a borrower's credit history considering numerous
factors such as:
- Late payments
- The amount of time credit has been established
- The amount of credit used versus the amount
of credit available
- Length of time at present residence
- Employment history
- Negative credit information such as bankruptcies,
charge-offs, collections, etc.
There are really three FICO scores computed by data provided
by each of the three bureaus––Experian, Trans
Union and Equifax. Some lenders use one of these three scores,
while other lenders may use the middle score.
Frequently Asked Questions (FAQs)
How can I increase my score? While it is difficult to increase
your score over the short run, here are some tips to increase
your score over a period of time.
- Pay your bills on time. Late payments
and collections can have a serious impact on your score.
- Do not apply for credit frequently. Having
a large number of inquiries on your credit report can worsen
your score.
- Reduce your credit-card balances. If you
are "maxed" out on your credit cards, this will
affect your credit score negatively.
- If you have limited credit, obtain additional
credit. Not having sufficient credit can negatively impact
your score.
What if there is an error on my credit report? If you see
an error on your report, report it to the credit bureau.
The three major bureaus in the U.S., Equifax (1-800-685-1111),
Trans Union (1-800-916-8800) and Experian (1-888-397-3742)
all have procedures for correcting information promptly.
Alternatively, your mortgage company may help you correct
this problem as well.
|
To understand why mortgage rates change we must first ask the more
general question, "Why do interest rates change?" It is
important to realize that there is not one interest rate, but many
interest rates!
- Prime rate: The rate offered to a bank's
best customers.
- Treasury bill rates: Treasury bills are
short-term debt instruments used by the U.S. Government
to finance their debt. Commonly called T-bills they come
in denominations of 3 months, 6 months and 1 year. Each
treasury bill has a corresponding interest rate (i.e. 3-month
T-bill rate, 1-year T-bill rate).
- Treasury Notes: Intermediate-term debt
instruments used by the U.S. Government to finance their
debt. They come in denominations of 2 years, 5 years and
10 years.
- Treasury Bonds: Long-debt instruments
used by the U.S. Government to finance its debt. Treasury
bonds come in 30-year denominations.
- Federal Funds Rate: Rates banks charge
each other for overnight loans.
- Federal Discount Rate: Rate New York Fed
charges to member banks.
- Libor: : London Interbank Offered Rates.
Average London Eurodollar rates.
- 6 month CD rate: The average rate that
you get when you invest in a 6-month CD.
- 11th District Cost of Funds: Rate determined
by averaging a composite of other rates.
- Fannie Mae-Backed Security rates: Fannie
Mae pools large quantities of mortgages, creates securities
with them, and sells them as Fannie Mae-backed securities.
The rates on these securities influence mortgage rates very
strongly.
- Ginnie Mae-Backed Security rates: Ginnie
Mae pools large quantities of mortgages, secures them and
sells them as Ginnie Mae-backed securities. The rates on
these securities influence mortgage rates on FHA and VA
loans.
Interest-rate movements are based on the simple concept
of supply and demand. If the demand for credit (loans) increases,
so do interest rates. This is because there are more buyers,
so sellers can command a better price, i.e. higher rates.
If the demand for credit reduces, then so do interest rates.
This is because there are more sellers than buyers, so buyers
can command a lower better price, i.e. lower rates. When
the economy is expanding there is a higher demand for credit,
so rates move higher, whereas when the economy is slowing
the demand for credit decreases and so do interest rates.
|
This leads to a fundamental concept:
- Bad news (i.e. a slowing economy) is good
news for interest rates (i.e. lower rates).
- Good news (i.e. a growing economy) is
bad news for interest rates (i.e. higher rates).
|
A major factor driving interest rates is inflation.
Higher inflation is associated with a growing economy. When the
economy grows too strongly, the Federal Reserve increases interest
rates to slow the economy down and reduce inflation. Inflation results
from prices of goods and services increasing. When the economy is
strong, there is more demand for goods and services, so the producers
of those goods and services can increase prices. A strong economy
therefore results in higher real-estate prices, higher rents on
apartments and higher mortgage rates.
Mortgage rates tend to move in the same direction as interest rates.
However, actual mortgage rates are also based on supply and demand
for mortgages. The supply/demand equation for mortgage rates may
be different from the supply/demand equation for interest rates.
This might sometimes result in mortgage rates moving differently
from other rates. For example, one lender may be forced to close
additional mortgages to meet a commitment they have made. This results
in them offering lower rates even though interest rates may have
moved up!
There is an inverse relationship between bond prices and bond rates.
This can be confusing. When bond prices move up, interest rates
move down and vice versa. This is because bonds tend to have a fixed
price at maturity––typically $1000. If the price of
the bond is currently at $900 and there are 10 years left on the
bond and if interest rates start moving higher, the price of the
bond starts dropping. The higher interest rates will cause increased
accumulation of interest over the next 5 years, such that a lower
price (e.g. $880) will result in the same maturity price, i.e. $1000.
A pre-qualification is normally issued by a loan officer, who, after
interviewing you, determines the dollar value of a loan you can
be approved for. However, loan officers do not make the final approval,
so a pre-qualification is not a commitment to lend. After the loan
officer determines that you pre-qualify, he/she then issues you
a pre-qualification letter. This pre-qualification letter is used
when you are making an offer on a property. The pre-qualification
letter indicates to the seller that you are qualified to purchase
the house you are making an offer on.
Pre-approval is a step above pre-qualification. Pre-approval involves
verifying your credit, down payment, employment history, etc. Your
loan application is submitted to an underwriter and a decision is
made regarding your loan application. If your loan is pre-approved,
you are then issued a pre-approval certificate. Getting your loan
pre-approved allows you to close very quickly when you do find a
house. A pre-approval can help you negotiate a better price with
the seller, since being pre-approved is very close to having cash
in the bank to pay for the house!
You cannot close a mortgage loan without locking in an interest
rate. There are four components to a rate lock:
- Loan program.
- Interest rate.
- Points.
- Length of the lock.
|
The longer the length of the lock, the higher
the points or the interest rate. This is because the longer the
lock, the greater the risk for the lender offering that lock.
Let's say you lock in a 30-year fixed loan at 8% for 2 points for
15 days on March 2. This lock will expire on March 17 (if March
17 is a holiday then the lock is typically extended to the first
working day after the 17th). The lender must disburse funds by March
17th, otherwise your rate lock expires, and your original rate-lock
commitment is invalid.
The same lock might cost 2.25 points for a 30-day lock or 2.5 points
for a 60-day lock. If you need a longer lock and do not want to
pay the higher points, you may instead pay a higher rate.
After a lock expires, most lenders will let you re-lock at the higher
of the current market rate/points or the originally locked rate/points.
In most cases you will not get a lower rate if rates drop.In some
cases, you may be able to negotiate a rate lock extension at the
original price, but this must be done with the lender prior to the
rate lock expiration date. An additional fee may be charged for
this extension.
Lenders can lose money if your lock expires. This is because they
are taking a risk by letting you lock in advance. If rates move
higher, they are forced to give you the original rate at which you
locked. Lenders often protect themselves against rate fluctuations
by hedging.
Some lenders do offer free float-downs––i.e. you may
lock the rate initially and if the rates drop while your loan is
in process, you will get the better rate. However, there is no free
lunch––the free float-down is costly for the lender
and you pay for this option indirectly, because the lender has to
build the price of this option into the rate.For example: the 'float
down' rate may be 0.125% to 0.25% higher than the current market
rate.
Most lenders will not budge unless the rates drop substantially
(3/8% or more). This is because it is expensive for them to lock
in interest rates. If lenders let the borrowers improve their rate
every time the rates improved, they spend a lot of time relocking
interest rates, since rates fluctuate daily. Also they would have
to build this option into their rates and borrowers would wind up
paying a higher rate. One option is to switch lenders. In this case,
you will be starting the loan process from the beginning, unless
you have your loan with a mortgage broker that will allow you to
move your loan application to a new lender at the lower rates, and
use the same loan package. It is always best to notify your lender
that you have shopped and found that rates have dropped, then discuss
your options with them before deciding to make a new application
elsewhere.
Lock-and-shop programs.
Most lenders will let you lock in an interest rate only on a specific
property,which means, if you are shopping for a home, you cannot
lock in an interest rate until after you sign a purchase contract
for a specific property. If you are shopping for a house, some lenders
offer a lock-and-shop program that lets you lock in a rate before
you find the house. This program is very useful when rates are rising.However,the
rates are usually higher than the current market rate and/or the
lender may charge a non-refundable fee or deposit towards closing
costs.
New-construction rate locks
Most lenders offer long-term locks for new construction. These locks
do cost more and may require an up-front deposit. For example, a
lender might offer a 180-day lock for 1 point over the cost of a
30-day lock, with 0.5 points being paid up-front, as a non-refundable
deposit. Most long-term new-construction locks do offer a float-down––i.e.
if rates drop prior to closing, you get the better rate.
Your loan can be sold at any time. There is a secondary mortgage
market in which lenders frequently buy and sell pools of mortgages.
This secondary mortgage market results in lower rates for consumers.
A lender buying your loan assumes all terms and conditions of the
original loan. As a result, the only thing that changes when a loan
is sold is to whom you mail your payment. If your loan has been
sold, your existing lender will notify you that your loan has been
sold, who your new lender is, and where you should send your payments
from now on.
If your lender goes out of business, you are still obligated to
make payments! Typically, loans owned by a lender going out of business
are sold to another lender. The lender purchasing your loan is obligated
to honor the terms and conditions of the original loan. Therefore,
if your lender goes out of business, it makes little difference
with regards to your loan payments. In some cases, there may be
a gap between the date of your lender's going out of business and
the date that a new lender purchases your loan. In such a situation,
continue making payments to your old lender until you are asked
to make payments to your new lender.
PMI or Private Mortgage Insurance is normally required when
you buy a house with less than 20% down. Mortgage insurance is a
type of guarantee that helps protect lenders against the costs of
foreclosure. This insurance protection is provided by private mortgage-insurance
companies. It enables lenders to accept lower down payments than
they would normally accept. In effect, mortgage insurance provides
what the equity of a higher down payment would provide to cover
a lender's losses in the unfortunate event of foreclosure. Therefore,
without mortgage insurance, you might not be able to buy a home
without a 20% down payment.
The cost of PMI increases as your down payment decreases. Example:
The cost of PMI on a 10% down payment is less than the cost of PMI
on a 5% down payment. Your PMI premium is normally added to your
monthly mortgage payment.
The decision on when to cancel the private insurance coverage does
not depend solely on the degree of your equity in the home. The
final say on terminating a private mortgage-insurance policy is
reserved jointly for the lender and any investor who may have purchased
an interest in the mortgage. However, in most cases, the lender
will allow cancellation of mortgage insurance when the loan is paid
down to 80% of the original property value. Some lenders may require
that you pay PMI for one or two years before you may apply to remove
it.
To cancel the PMI on your loan, contact your lender. In most cases,
an appraisal will be required to determine the value of your property.
You will probably also be required to pay for the cost of this appraisal.
Another way of cancelling the PMI on your loan is to refinance and
to get a new loan without PMI.
The annual percentage rate (APR) is an interest
rate that is different from the note rate. It is commonly used to
compare loan programs from different lenders. The Federal Truth
in Lending law requires mortgage companies to disclose the APR when
they advertise a rate. Typically the APR is found next to the rate.
Example: 30-year fixed 8% 1 point 8.107% APR
The APR does NOT affect your monthly payments.
Your monthly payments are a function of the interest rate and the
length of the loan.
The APR is a very confusing number! Even mortgage bankers and brokers
admit it is confusing. The APR is designed to measure the "true
cost of a loan." It creates a level playing field for lenders.
It prevents lenders from advertising a low rate and hiding fees.
If life were easy, all you would have to do is compare APRs from
the lenders/brokers you are working with, then pick the easiest
one and you would have the right loan. Right? Wrong!
Unfortunately, different lenders calculate APRs differently! So
a loan with a lower APR is not necessarily a better rate. The best
way to compare loans in the author's opinion is to ask lenders to
provide you with a good-faith estimate of their costs on the same
type of program (e.g. 30-year fixed) at the same interest rate.
Then delete all fees that are independent of the loan such as homeowners
insurance, title fees, escrow fees, attorney fees, etc. Now add
up all the loan fees. The lender that has lower loan fees has a
cheaper loan than the lender with higher loan fees.
The reason why APRs are confusing is because the rules to compute
APR are not clearly defined.
What fees are included in the APR?
The following fees ARE generally included in the APR:
• Points - both discount points and origination points
• Pre-paid interest. The interest paid from the date the loan
closes to the end of the month. Most mortgage companies assume 15
days of interest in their calculations. However, companies may use
any number between 1 and 30!
• Loan-processing fee
• Underwriting fee
• Document-preparation fee
• Private mortgage-insurance
The following fees are SOMETIMES included in the APR:
• Loan-application fee
• Credit life insurance (insurance that pays off the mortgage
in the event of a borrowers death)
The following fees are normally NOT included in the APR:
• Title or abstract fee
• Escrow fee
• Attorney fee
• Notary fee
• Document preparation (charged by the closing agent)
• Home-inspection fees
• Recording fee
• Transfer taxes
• Credit report
• Appraisal fee
An APR does not tell you how long your rate is locked for. A lender
who offers you a 10-day rate lock may have a lower APR than a lender
who offers you a 60-day rate lock!
Calculating APRs on adjustable and balloon loans is even more complex
because future rates are unknown. The result is even more confusion
about how lenders calculate APRs.
Do not attempt to compare a 30-year loan with a 15-year loan using
their respective APRs. A 15-year loan may have a lower interest
rate, but could have a higher APR, since the loan fees are amortized
over a shorter period of time.
Finally, many lenders do not even know what they include in their
APR because they use software programs to compute their APRs. It
is quite possible that the same lender with the same fees using
two different software programs may arrive at two different APRs!
Conclusion :
Use the APR as a starting point to compare loans. The APR is a result
of a complex calculation and not clearly defined. There is no substitute
to getting a good-faith estimate from each lender to compare costs.
Remember to exclude those costs that are independent of the loan.
|
