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Refinance

Why Refinance?

Fundamentally, people refinance because they either want to save money or spend money. This article discusses the most common circumstances in which you might save money by refinancing.

One way to save money is to obtain a loan with a shorter life compared to your current loan. For more information, read
Switching to a 15 year loan. If you are attempting to save money by reducing your interest rate, read Should I pay points or closing costs? and Switching to a 15 year loan. If you are attempting to save money by consolidating debt, read Cash Out Refinance.

There may be conditions which require you save money in the short-run. An Adjustable Rate Mortgage (ARM) with a low start-rate can temporarily lower your mortgage payments. Depending on the loan, you could substantially reduce your payments for a year or more.

You might believe you'll save money in the long-run by switching from an ARM to a fixed-rate loan--and you could be right. In this case, you're assuming that rates will eventually increase enough to justify the cost of refinancing. There is less certainty of saving money in this scenario because the future is unknown and rate comparisons are hypothetical.

Whatever your reason for refinancing, the process begins by comparing the various loan options you have available, including keeping your current loan. Real estate loans usually have income tax effects. Before rushing into a new loan, consider having your figures checked by your tax advisor. Talk to your current lender. They may reduce some of their fees in an effort to keep your business, or because they may have reduced paperwork.

For each loan you are considering, obtain an amortization schedule and Good Faith Estimate (GFE). A complete amortization schedule will identify the principal and interest portion of your monthly payments over the life of the loan. With it, you can accurately determine the interest paid within any time period. The (GFE) will itemize costs associated with obtaining the loan. The immediate costs of the transaction will be shown on the GFE, while the interest expense over time will appear on the amortization schedule. The information in these documents is required to make an informed decision regarding the best loan for you.

Zero Point / Zero Fee Loans

The Hype

"Now you can lower your monthly payment at no cost to you." Sound familiar? Many people took advantage of the historic downtrend in interest rates during the 1990s. Reducing your monthly payment can be, and often is a good idea. If you invest the monthly savings, you'll be doing everything possible to maximize the benefits of refinancing. In the 90s, many people refinanced numerous times with zero-point/fee loans--and why not? When you can lower your mortgage payment for "free", shouldn't you always do so? As you'll see, simply because you can refinance with a zero-point/fee loan, doesn't mean you should.

The mechanics

Rebate pricing (yield spread pricing, service-release premium) makes zero-point/fee loans possible. Simply put, you pay a higher-than-market interest rate in exchange for cash. The cash is used to pay your closing costs. Here is a hypothetical example of rate/points combinations. The negative points are rebates. One point is 1 percent of the loan amount.

7.25%,   2 points
7.75%,   1 point
8.00%,   0 points
8.50%,  -1 point
9.00%, -2 points

On a $100,000 loan, you can pay 8 percent interest and receive two points, ($2,000) which you can use to pay your closing costs.

What are the benefits of a zero-point/fee loan?

You can lower your monthly payment with no out-of-pocket expenses. In the short-run, you can save money. There may be some recurring costs collected from you at closing, but you'd pay these costs if you didn't refinance. They are not a cost of the transaction. Recurring costs include property taxes, insurance and pre-paid mortgage interest.

What are the disadvantages of a zero-point/fee loan?

The obvious disadvantage is that you're paying a higher rate in order go obtain the rebate. If you pay closing costs from your personal funds, you receive a lower interest rate. If you keep the loan long enough, (approximately two to three years) you'll pay more than if you had paid points, closing costs and received a lower rate. 

Not quite as obvious is something that can happen each time you refinance: you extend the time you have a mortgage. Suppose you purchase a home and obtain a $100,000, 9 percent, 30-year, fixed-rate loan. After three years your loan balance is $97,750. You get a new, $97,750, 8.5 percent, 30-year, zero-cost/fee loan. After another three years your loan balance is $95,330. You obtain a new, $95,330, 8 percent, 30-year, zero-cost/fee loan. You keep the 8 percent loan and pay it off over 30 years. This scenario may seem unlikely, but many people refinanced this way more than once in the 90s. In this situation, refinancing cost more than holding the original, 30-year, 9 percent mortgage. This scenario will cost more because you twice exchanged a 27-year mortgage for a 30-year mortgage. Your home will be mortgaged for thirty-six years instead of thirty.

Zero-point/fee loans can be advantageous. Make sure the rebate covers your closing costs. Don't increase your new loan amount by adding your closing costs to it. For example if your old loan amount was $100,00, your new loan amount should be $100,000. Zero-point/fee loans are especially attractive when rates are declining and you plan to sell your home in fewer than two to three years.

Should I Pay Points?

There is an inverse relationship between points and interest rate on your loan. The higher the points you pay, the lower the interest rate, and vise versa.

There are fees other than points associated with a loan transaction, but for a given loan amount and service provider, these other fees are fundamentally fixed. Other fees may include appraisal, credit report, lender's inspection, tax service, processing, underwriting, wire transfer, flood certification, title and escrow fees, notary fees, recording fees, etc. For example, consider a $100,000, 30-year, fixed rate loan on a home valued at $200,000. No matter what the points and interest rate you pay, an independent appraiser won't give you a "zero-fee appraisal", nor will a title company give you rebate pricing for a policy of title insurance.

Because of the inverse relationship between points and interest rate, you can obtain a rebate from the lender to cover some or all of your points and other fees. By increasing the interest rate on your loan, the lender might pay some or all loan fees. By reducing the interest rate on your loan, you'll pay some or all of the loan fees.

As a borrower, you should answer these questions before you commit to a new loan: Should I obtain a lower interest rate, pay points, loan fees, or both? Should I get a higher interest rate and reduce out-of-pocket fees? To answer these questions, estimate how long it will be until you plan to sell or refinance. The task then becomes finding the interest rate / fee combination which is the least expensive during this window of time.

Here is a hypothetical example. For simplicity, "other fees" are fixed at $1,000. You own your home and are interested in refinancing your high-interest loan to take advantage of a new, low-interest loan. The interest rates for zero point / zero fee loans are well below your current rate, so you know it's time to refinance. Your employer has indicated you might be transferred in approximately three years. You compare three rate / fee combinations to identify which is the least costly over the next three years. You're considering a 30-year, fixed loan.

Comparing the expense of different loans allows us to consider only the interest portion of the monthly payments. The principal portion of the monthly payment is not considered an expense. Therefore, only the interest portion of the monthly payments are considered in these examples. A financial calculator or spreadsheet program can provide the interest portion of the monthly payments. Here are the loan comparisons.

Loan:  30-year, fixed, $100,000, 8.0%, monthly P&I payment = $733.82
Month12. . .2324
8.0%Interest666.67666.22 656.11655.59
 Points0    
 Other Fees0    
 Cumulative Total666.67   1332.89  15,214.7015,870.29


Loan:  30-year, fixed, $100,000, 7.5%, monthly P&I payment = $699.28
Month12. . .2324
7.5%Interest625.00624.54 614.10613.57
 Points0    
 Other Fees1,000    
 Cumulative Total1,625.002,249.54 15,252.3515,865.91


Loan:  30-year, fixed, $100,000, 7.0%, monthly P&I payment = $655.37
Month12. . .2324
7.0%Interest583.33582.86 572.14571.60
 Points1,000    
 Other Fees1,000    
 Cumulative Total2,583.333,166.19 15,290.6115,862.21

The cumulative total for each loan represents the total expense related to the loan at the end of a given month. Initially, the expense of the 8 percent loan is much lower compared to the others because the 8 percent loan is free of out-of-pocket closing costs. The 7.5 percent loan is a zero point, $1,000 closing costs loan. The 7 percent loan example requires the borrower to pay points and fees. Initially, the 7 percent loan is the most expensive. At the end of month twenty-three, the 8 percent loan is still the least expensive. At the end of month twenty-four, the 7 percent loan is the least expensive. If we were to carry out these examples, the 7 percent loan would continue to be the least expensive. This comparison suggests that you should take the 7 percent loan. You'll be in your home for three years, and beginning in the second year you start saving money with the 7 percent loan.

What are Closing Costs?

When refinancing your home loan, you'll probably have to pay closing costs. Don't be mislead by zero point, zero fee loans. Even though the lender might appear to pay your closing costs, you'll likely pay a higher interest rate to reimburse the lender. Closing costs can be separated into two types: recurring and non-recurring.

  • Non-recurring costs:  These are fees directly resulting from the loan transaction. They can be paid by you from savings, sometimes financed by adding them onto the loan amount, or "paid" by the lender.
  • Recurring costs:  These are costs that you have to pay whether you refinance or not. However, when you refinance, you may have to pay them sooner than you otherwise would. These costs include property insurance, property taxes and prepaid interest on your new loan. If your new lender requires an impound or escrow account for taxes or insurance, you pay to setup this account. If your previous lender required an impound or escrow account, the balance will be reimbursed.

Here is a hypothetical example of a closing costs statement. Your situation will likely be different. Ask your loan officer to provide you with a similar estimate when you apply for a loan.

HUD No.DescriptionAmount
800Items Payable in connection with the loan. 
801Loan Origination Fee (Points)$2,000
802Loan Discount Fee$1,000
803 Appraisal Fee$300
804Credit Report$50
809Tax Related Service Fee$79
810Processing Fee$300
811Underwriting Fee$250
812Wire Transfer Fee$50
900Items Required by the Lender to be paid in advance 
901Interest for 15 days$700
902Mortgage Insurance Premium$250
903Hazard Insurance Premium$500
1100Title Charges 
1101Closing or Escrow Fee$600
1105Document Preparation Fee$75
1107 Attorney Fees 
1108Title Insurance$800
1200Government Recording and Transfer Charges 
1201Recording Fees$50
1202City/County Tax/Stamps 
1203State Tax/Stamps 
1300Additional Settlement Charges 
1302Pest Inspection 

You may be wondering why there are so many fees associated with getting a loan. There are several parties providing various services in a real estate loan transaction. Relatively few charges provide profit for the lender or mortgage broker. The majority of fees are associated with services designed to protect the lender. Appraisal, credit, tax service, underwriting, mortgage insurance, hazard insurance, title and escrow, recording, etc., are all services which in some way protect the lenders interest.

Here is a brief description of the functions of some of the service providers associated with obtaining a real estate loan.

  • Mortgage broker or loan officer. She helps you complete your loan application and is your main contact in the transaction. She collects supporting documents, orders all verifications (employment, deposits, etc.), and obtains your credit report. She should keep fully informed and should communicate with you regarding the status of the transaction. She may delegate many tasks to others while overseeing the entire process.
  • Loan processor. She may be an employee of the financial institution from which you're getting your loan, or of the broker with whom you're working. The processor's tasks include checking your credit, ordering an appraisal, verifying your financials and packaging your file in the correct format for submission.
  • Underwriter. She is usually an employee of the financial institution. She reviews your completed file, sees if it fits the lender's specifications, and issues your approval, conditional approval, or denial.
  • Appraiser. She examines the property being purchased or refinanced, and provides a professional opinion of its value. The appraisal report is included in your file when it is delivered to the lender's underwriter.
  • Escrow officer, title officer or attorney. Title and escrow are different services, but are usually offered by the same company. Title companies or attorneys receive all the funds involved in the transaction, account for them, make all payments to interested parties, and in the case of title companies, issue title insurance.

Are points tax deductible?

"Points" are considered prepaid, home mortgage interest by the Internal Revenue Service. In the loan industry, they are also referred to as discount points, origination fees, maximum loan charges or loan discount. They are usually fully tax deductible in the case of a home purchase, construction of a home, or home improvement. This article addresses the tax deductibility of points associated with a home purchase. For complete information about home mortgage interest, go to www.irs.gov, or contact your tax advisor.

In order to deduct home mortgage interest, these three conditions must apply to you:

  1. You file Form 1040 and itemize your deductions on Schedule A.
  2. You are legally obligated to repay the loan. If you make mortgage payments for a friend, and you're not legally required to make the payments, you can't deduct the interest.
  3. The mortgage must be secured on your main or second home.

Generally, you must deduct points over the life of the loan. I.e., for a 30-year loan, you may deduct 1/30 of the points each year. In the event you still have a loan balance when you sell your home, you may deduct the balance of the points not previously deducted. If your mortgage ends, and the full amount of the points have not been deducted, you may deduct the balance of the points when the mortgage ends. If you refinance your loan with the same lender, you can't deduct the balance of the points in that year. Instead, you must deduct them over the life of the new loan.

For the tax year in which you purchased your home, you may deduct the full amount of the points you paid for a home purchase if all these conditions apply to you:

  1. Your loan is a lien upon (secured by) the home you live in most of the time (main home).
  2. Paying points is the norm for the area in which your loan was made.
  3. The amount of points paid were not excessive for the area in which you obtained your loan.
  4. You use the cash method of accounting (most people do).
  5. The points were not paid in lieu of other fees, such as appraisal, title, attorney, etc.
  6. The purpose of your loan was to buy the home you live in most of the time.
  7. The points were based upon a percentage of the loan amount. For example, 1% loan fee.
  8. The amount and type of charge is explicitly stated as points in your closing documents (Uniform Settlement Statement, Form HUD-1). Points are deductible on your tax return if the Seller pays them.
  9. The total amount of money you paid to close the loan (not borrowed from the lender), including your down payment, title, escrow, closing agent fees, etc., must be at least as much as the points charged. These funds, however, do not have to have been applied to paying points.

The information contained herein is intended for general information purposes only. This information is not tax advice, nor should any actions or decisions be based upon any information contained herein. For tax advice, consult your tax advisor.

Cash Out Refinance

There are many good reasons to refinance your current mortgage, or get a second mortgage and pull equity out of your home. Here are just a few.

  1. Structural additions or improvements to your home.
  2. Obtaining funds for investment.
  3. College tuition for your children.
  4. Paying off other debt, such as credit cards, in order to reduce your total monthly outlay.

Improving your home can increase its value. Investing wisely can help create a larger net worth. Both could pay off in retirement benefits for you.

Arguably, item four can help create wealth by lowering your monthly outlay, but this item lends itself to a different discussion. In recent years, many have experienced the best of both worlds regarding consuming and borrowing. People have been able to refinance a high-interest loan, consolidate credit card debt into a new, low-interest loan, and end up with a larger mortgage with a lower monthly outgo. Don't count on these economic conditions being available when you want to borrow against your home.

It's easy to think of numerous reasons to borrow and spend. We're inundated daily with messages to consume--and most of us are pretty good at it. Certainly there are times when borrowing can't be avoided, such as when buying a home. Be very careful when you think of your home as a source of funds for consumption, however. If you find it hard to get rid of your credit card debt and think borrowing against your home is a good idea--think again. You might be better off calling a credit counselor for budgeting assistance, instead of calling a bank for a new first or second mortgage. Credit card debt won't cost you your home if you don't pay it back. A mortgage will cost you your home if you don't pay it back.

Pulling equity out of your home can provide important benefits. Be careful. Don't risk the security of your home on frivolous spending.

Switching to a 15 year loan

Question: How do you determine if you should "exchange" your current 30-year loan for a 15 year loan?

Assuming you want to save money, the question is usually easily answered. 1) Multiply the monthly payment on your current, 30-year loan by the remaining number of payments. 2) Multiply the monthly payment of a potential 15-year loan by 180. Compare the two totals. The answer should jump out at you--especially if your 30-year loan is relatively new. A 30-year loan is usually far more expensive compared to a 15 year loan. I.e., you'll pay much more in interest with a 30-year loan compared to a 15 year loan. If your budget allows for the relatively higher payment of a 15-year loan, "exchange" your current loan for the 15 year loan.

How you exchange your 30-year loan for a 15-year loan is the next question. There are many different and valid ways of answering it. You could compare loans based upon total interest paid, before- or after-tax figures, Internal Rate of Return (IRR), Net Present Value (NPV), etc. Different methods evaluate to different numbers, but any valid method will identify your best choice.

The examples below are evaluated using the Net Present Value (NPV) method of investment analysis (for a different method of comparing loans, see Should I pay points or closing costs? NPV is employed for several reasons. The function is easily accessible via a financial calculator or spreadsheet program. NPV accounts for the time-value of money, investment risk, and requires relatively few calculations. Amortization and calculation of interest are not necessary. An NPV exists even when the IRR is undefined. When using NPV, be sure to compare investments with equal lives.

Simply put, the NPV is a measure of wealth. When selecting among several investments, the investment with the largest NPV should be chosen. In our examples, the NPVs are negative. You still select the loan program with the largest NPV--the one which is the least negative.

The first step in calculating NPV is to determine the amount and "direction" of the cash flows. In our examples, the loan amount is a positive cash flow--the borrower receives it. The payments are negative cash flows--the borrower pays them. To make our job easier, we'll use 15 annual cash flows, not 180 monthly cash flows. For the first cash flow--the loan amount--you must account for any loan fee you might pay. For example, if you get a $95,000 loan and pay a 1 percent loan fee ($950) from savings, your first cash flow is $95,000 – $950 = $94,050.

Hypothetical Example

Five years ago you obtained a $100,000, 30-year, fixed, 8 percent loan with monthly payments of $733.76. The balance on your loan is approximately $95,070--call it $95,000. If you keep this loan, you'll pay approximately $220,129 over the next 25 years (300 x $733.67). A quick look at a new, $95,000, 15-year loan at 7.375 percent shows total principal and interest payments for 15 years totaling approximately $157,308. The difference definitely jumps out at you and you don't need to go any farther to correctly understand that a 15-year loan is going to save you money. The next question is, what is the best 15 year loan to select?

Four options are considered. 1) Refinance your current, 30-year loan for a 15 year loan and pay the closing costs from savings, 2) Refinance your current loan for a 15-year loan and finance the closing costs by including them in your new loan, 3) Refinance your current loan for a 15-year, zero point loan, 4) begin paying your current, 30-year loan as it if were a 15 year loan (rarely will you incur any penalty for doing this, but check with your lender first). The least expensive choice is example one--the choice with the largest (least negative) NPV. The interest rates and fees used for the examples reflect the market differences between a 30-year and 15-year loan as of the date of this writing.

Eg. 1. New 15 yr. loan, 7.375%, borrower pays 1 point loan fee from savings.
CF 0: Borrower's initial cash flow = $95,000 – $950    $94,050.00
CF 1 - 15: Borrower's annual payment: ($873.93 x 12)– $10,487.13
NPV – $ 7,362
 
Eg. 2. New 15 yr. loan, 7.375%, borrower finances 1 point loan fee.
CF 0: Borrower's initial cash flow = $95,950 – $950    $95,000
CF 1 - 15: Borrower's annual payments: ($882.67 x 12)– $10,592.00
NPV– $ 7,427
 
Eg. 3. New 15 yr. loan, 8%, 1 point rebate pays loan fee. Increased interest rate required to obtain 1 point rebate.
CF 0: Borrower's initial cash flow = $95,000    $95,000
CF 1 - 15: Borrower's annual payments: ($907.87 x 12)– $10,894.43
NPV– $10,198
 
Eg. 4. Keep current, 8% loan, make payments based on 15 yr. amortization. (This is the same as eg. 3.)
CF 0: Borrower's initial cash flow = $95,000    $95,000
CF 1 - 15: Borrower's annual payments: ($907.87 x 12)– $10,894.43
NPV– $10,198