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To Refinance Or Not To Refinance
Kevin J. Daum
This article was originally published in a 2006
edition of Log Homes Illustrated magazine.
With the housing boom slowing and interest rates seemingly higher, why would anyone think of looking at a refinance? Certainly anyone with real estate already refinanced down to a low rate at some point in the last 5 years and is now enjoying the benefit of that savings in interest. Perhaps however in the feeding frenzy of mortgage mayhem, there was information missed in determining the best loan for your needs. Or maybe your needs have changed. Now is a good time while mortgage rates are still low to re-explore reasons to refinance as well as evaluate the proper approach to managing your single biggest liability and payment generator, your mortgage.
Do you really have the right loan?
The mortgage market has been inundated with new products and new people selling them. Believe it or not 30 years ago you could only choose from a fifteen year or thirty year fixed fully amortized loan. Today we have fixed for five years, seven years or ten years, all of course with “Interest Only” options and if that is not enough variety you can pick from a wide choice of adjustable rate mortgages with a large mixture of margins, caps and indices. Oh and don’t forget the Option ARMS with payment choices that allow for low payments with potential negative amortization.
If all these choices seem difficult for you to navigate you are not alone. Unfortunately many of the Loan Officers who came into this industry during the boom didn’t get proper training and were focused solely on providing the consumer with their request instead of providing education and analysis to assess the right loan for the right borrower. It’s very possible that the loan that sounded great at the time is the wrong loan for you today. Here are the major issues to examine that will help you insure you have the right loan for right now.
Is your rate going to last?
Many people opted for short term fixed rates in the last refi boom. If you took on a loan fixed for three, five or even seven years you may be nearing the end of that low interest rate period depending on when you last refinanced. Now is the time to consider grabbing a new loan for the next five to seven years. Even though rates have increased over the last year and a half the mortgage rates have remained remarkably low relative to the last twenty five years. At the time of my writing this article long term fixed rates are ranging from 5.5 to 6.5 percent depending upon the size of your loan and qualifications. Short term fixed loans are lower by as much as .75 percent.
If you are on a short term mortgage and plan to stay in your house than the question is not “Are you going to refinance?” but rather “When are you going to refinance?” Most likely you will be unhappy with the rate when your loan rolls to its inevitable adjustable phase. Your payment will definitely go up and if you took the Interest Only option it could more than double your payment as it amortizes the balance. Refinancing now can assure you of locking in a lower payment at today’s decent rates and will likely result only in a payment increase of roughly ten to twenty percent. If the rates go down again you can always refinance to the lower rate as long you avoid prepayment penalties.
Do you still have an equity line?
A popular safety net approach for many consumers was to take a low balance first mortgage and give themselves a cushion by opting for a Home Equity Line Of Credit (HELOC). While some people never touch the money in this line, more often than not consumers draw upon it for major expenses such as home improvement, medical expenses, weddings or college educations with the full intention of paying it down later and reducing the payments. In actuality statistically very few HELOCs are paid down and much fewer paid off. If you find yourself in the position of having an outstanding HELOC balance you could be overpaying on your interest even if you have a low rate on your first mortgage.
HELOCs are generally based on prime and most float on a monthly basis. This means you probably watched your rate go up steadily over the last couple of years while the Federal Reserve attempted to control inflation and create their “Soft Landing” for the economy. The good news is that today’s rates may be lower than your “blended” rate. If your HELOC rate is prime plus one for example the rate is at 9.25 percent today. That high rate may be negating the benefit of the lower rate on your first mortgage.
Here is a quick way to see if you can benefit from a refinance. Take the payment on your HELOC and add it to your first mortgage payment. Use only the interest amount off your statement if you are on an amortized loan. Multiply the total by 12 to get the annual interest amount and divide that total by the total amount owed. This is your blended rate.
Example:
First mortgage 425,000 at 5% = $1770.83
HELOC $150,000 at prime + 1 (9.25%) = $1156.25
Total Monthly Payment $2927.08
Multiplied by 12 for annual interest $35,124.96
Divided by $575,000 for blended rate = 6.1%
In this example you can save money and protect yourself from future prime rate increases by refinancing to a rate lower than 6.1%. A new five year fixed at 5.5% could save you $3,450 a year.
Do you have an Option ARM?
Option ARMs were popular payment savings tools during the refi boom. The good part of these loans is the flexibility it offers to the consumer every month to pay a fully amortized payment or make an interest only payment or even make a lower payment subsidized by the increasing equity of the house. Often these loans were used to help people get into a home when their earning capability wasn’t rising as fast as home prices. The bulk of these loans are based upon short term interest rates which change monthly and were lower than fixed rates over the last several years.
Changes in the market however have created an interesting dynamic called an “inverted yield curve” which means that short term rates are actually higher than long term rates causing the interest rates on these Option ARMS to rise almost 2 percent higher than the current long term mortgage rates. Many consumers haven’t reacted to the dramatic rate increases yet since their payments only change gradually.
Consumers can save significantly by refinancing their Option Arms onto longer term fixed rate loans but they will have to ready themselves for a stiff payment increase. A current client of mine with a $650,000 loan will pay $1000 more in his minimum monthly payment but he is saving $9500 annually with this change. If you can afford the increased payment the change is definitely worth the savings. If you aren’t using the minimum payment option and have been paying interest only you will see the savings benefit immediately.
Do you need money in the next 5 years?
This is always the key question when considering a refinance. Many people are emotionally averse to taking money out of their house unless they absolutely have to. Some are afraid to manage large sums of money fearful they may invest it unwisely. Others simply don’t realize they can put the money in safe places with decent yields today. For example Certificates of Deposit are now exceeding 5.5 percent.
Along comes a need such as medical, college, wedding, home improvement, etc. and the house is the first place to go. Having already addressed the issues with HELOCs today, there is no need to rehash the benefit of refinancing to obtain the needed funds today while the rates are still low. Depending on your situation there may be additional tax benefits as well that you can discuss with your CPA. The time is now to think about planning ahead. If you do proceed with a refinance for any reason you should take all the money you anticipate needing now so you don’t have to go back later when rates may be higher.
Consider all the factors
Refinancing won’t be free. There will be closing costs involved. Even zero point zero fee options can cost you with higher interest rates. Some low cost loans will also have prepayment penalties which could prohibit you from selling or refinancing in the near future without costing thousands of dollars. Make sure you calculate the total closing costs into the loan and check to see how many months it will take you to recoup the cost of the loan in monthly payment savings. Note that often you will make up the cost faster by paying points which can be tax deductible rater than opting for the zero point option so do the math.
Even though the real estate market bubble frenzy appears to have subsided with the slow leak rather than the big bust, property values can still be an issue when refinancing. Those of you who maxed out the cash or purchased with nothing down in the last two years may not have enough equity to support a refinance yet. Luckily there are still many options for people at 90 percent and even 95 percent Loan-to-Value so by all means go ahead and investigate your options to save money. You may still need a combination first mortgage and HELOC to restructure your loan but if the bottom line means net savings for you its definitely worth your consideration.
The most important aspect or refinancing in this market is taking the time to work with the right professional. Many fly-by-night Loan Officers have now left the business and those serious about being in the mortgage industry long term have stayed on. This is your chance to find someone truly knowledgeable and ethical to educate you and help you figure out which options are actually going to benefit you long term. With the slowdown, even the most experienced Loan Officers have a little more time to spend with you so take advantage of it. Find a real expert and really investigate your options before the frenzy starts up once more.
Kevin Daum is the Founder and CEO of Stratford Financial
Services, a Real Estate finance and education company, founded
in 1989. Stratford specializes in Purchase loans, Refinance
loans and Custom Home Construction finance and has successfully
financed thousands of clients. He is the author of "Building
Your Own Home for Dummies" (Wiley), as well as "What
the Banks Won’t Tell You." Mr. Daum was an Underwriter
for Plaza Savings and Loan and Key Bank of New York. He is
an INC 500 CEO and has been listed as one the 40 Most Influential
People Under 40 in the San Francisco Bay Area. He is the Global
Chair for the Edison Innovation Program with the Young Entrepreneurs'
Organization (YEO) and is a founding Board member of the Bay
Area Chapter of YEO.
Mr. Daum is a frequent contributor to numerous business
publications on the subjects of Real Estate and Small Business
leadership and speaks regularly on both subjects. He can be
contacted at kevin@stratfordfinancial.com.
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