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Obtain a new loan to pay off an older one.
Paying off an old loan while simultaneously taking a new one.
Borrowers may refinance to reduce Interest Cost or to raise cash. These are very different decisions based on different considerations.
Refinancing to Lower Interest Cost: To lower interest cost by refinancing, the new interest rate must be lower than the old one.
It is possible to reduce interest payments (as distinct from interest cost) by refinancing into a new loan with a higher interest rate combined with higher payments. The higher payments shorten the payoff period and reduce total interest payments. You don't need to pay a higher rate, however, to shorten the payoff period. See Mortgage Scams and Tricks/ Strictly Lender Scams/Sell Biweeklies Under False Pretenses.
Measuring the Costs and Gains: The best way to measure the costs and gains from refinancing is to compare all costs of the existing mortgage and a new mortgage over a future period. The period should be your best guess as to how long you will have the new mortgage. If the total costs are lower with the new mortgage, you should refinance.
Calculator 3a on my Web site shows all the costs over a specified period of an existing and a new mortgage side by side. It also shows the break-even period, which is the minimum length of time the borrower must hold the new mortgage to make the refinancing pay. So if you are confident that you will have the mortgage longer than the break-even period, you know the refinance pays. If you hate calculators, use the break-even tables below.
Aside benefit from using a calculator is that it forces you to collect all the information that affects the profitability of a refinance. Once all the relevant information is at hand, it is clear that no two cases are exactly alike. But the calculator will handle them all.
Avoid This Common Rule of Thumb: Loan officers often calculate a break-even period by dividing the cost of the loan by the reduction in the monthly mortgage payment. For example, if it costs $4,000 to refinance and the monthly payment falls by $200, the break-even would be 20 months.
This rule of thumb does not take account of differences in how rapidly you pay down the balance of the new loan as opposed to the old one, it does not allow for differences in tax savings (which depend on the borrower's tax bracket), and it ignores differences in lost interest on upfront and monthly payments. All these factors are taken into account by calculator 3a.
Financing Upfront Costs: Lenders ordinarily allow refinancers to fold the settlement costs into the loan amount without classifying it as a “cash-out.” For example, if the balance on the old loan is $100,000 and settlement costs including the lender's fees are $3,750, the new loan could be for $103,750.
Financing the settlement costs, however, reduces the gains from refinancing because the borrower must pay interest on the costs at the mortgage rate. Financing the costs, furthermore, can flip the loan amount above 80% of property value, which triggers mortgage insurance. If the borrower is already paying mortgage insurance, it can raise the premium. Calculator 3a includes a financing option and automatically factors mortgage insurance into the cost calculation, if it arises.
No-Cost Refinance: A no-closing-cost loan is one where the interest rate is high enough to command a rebate from the lender that covers the closing costs. This is very different from a no-cash outlay loan, where closing costs are added to the loan balance. Note that even with a legitimate no-cost loan, borrowers should always expect to pay per diem interest and escrows at closing.
The no-cost option is for borrowers who are sure to have the mortgage for no more than five years. Either they plan to sell the house within that period or they are convinced that interest rates will fall further and they will refinance again. For further discussion, see No-Cost Mortgage.
Refinancing Versus Contract Modification: Many borrowers wonder why they can't induce their lender to agree to a modification of the rate on the existing loan. If the old loan stays on the books, the settlement costs required by a new loan are avoided and both the borrower and the lender can be better off.
Contract modifications do occur, but not very often. In most cases, the lenders to whom borrowers send their payments don't own the loans. They are the servicing agents of the owners. Ordinarily, owners will not grant servicing agents the right to modify the interest rate. Owners fear that agents would agree to rate reductions too readily in order to retain their servicing income, which is not affected by a reduction in the interest rate.
Even when the servicing agent owns the loan, it will not volunteer a rate reduction. The lender's objective is to drop the rate only if necessary to prevent the borrower from refinancing with another lender. Borrowers who understand this will take the initiative to let the lender know their intentions. The best way to do this is to request a payoff statement. This tells the lender that you have begun a refinance process with another lender.
Don't Confuse “Better Off” with “Best”: The fact that a refinancing lowers your cost doesn't mean you should do it. Another mortgage may be available that would save you even more. If you are happy with your savings at a rate above the market, the loan officer will be happy too.
Refinance Versus Extra Payments: Many borrowers get confused over how the decision to make extra payments bears on their decision to refinance. It is complicated, but here are some guidelines:
• Ignore extra payments made in the past: that's water over the dam.
• Looking ahead, consider first whether you want to repay your loan in full. Repayment is an investment on which the yield is the rate at which you could refinance with no upfront costs. (If you can refinance your current loan at 6%, for example, you earn 6% by paying it off.) Compare this with the returns on your investment alternatives. If you repay in full, the process ends.
• If you elect not to repay in full, consider whether refinancing pays if you make the extra monthly payments that you can afford. Extra payments reduce the benefit from refinancing. You factor them into your analysis, using my refinance calculators, by shortening the term of your new mortgage. If you plan to refinance into a 15-year loan, for example, but extra payments would result in payoff in 10 years, you use 10 years as the term. You can determine the payoff period from any extra payments using my calculator 2a. If refinancing is beneficial assuming extra payments, you refinance—end of process.
• If refinancing is not profitable with the extra payments, do the analysis again without the extra payments. If refinancing remains unprofitable, you don't refinance. But if refinancing is profitable without the extra payments, you flip a coin: heads you refinance without extra payments, tails you make extra payments without refinancing.
Refinancing When You Have Two Mortgages: Two mortgages complicate the refinance decision. You can refinance the first alone (provided the second mortgage lender allows it, see Subordination Policy), you can refinance the second alone, you can refinance both into two new mortgages, and you can refinance both into one new mortgage.
You can analyze the first three possibilities using my calculator 3a and the 4th using 3b. You must obtain price quotes on a new first for the amount of the balance on the existing first, on a new second for the amount of the balance on the existing second, and a new first for the amount of the balance on both existing loans.
Effect of Prior Refinances on the Current One: When interest rates drop, some homeowners who had refinanced earlier are discouraged from refinancing again, for reasons that make no sense.
Some homeowners assume that there must be a waiting period before they are allowed to refinance again. This is not the case.
Of course, lenders hate serial refinancing with a passion, but it is a cost of doing business. While loan contracts may discourage refinancing with a prepayment penalty, in jurisdictions where such penalties are allowed, that is a different issue.
Some homeowners are reluctant to refinance the second time because it means they “have to start all over again.” One borrower commented that “I have already paid five months of the term and am reluctant to give that up.”
But she gives up nothing. In the five months she had the loan, she reduced the balance by an amount equal to the five principal payments she made. If she refinances, it will be on this lower balance, so her savings remain intact.
It is true that if she refinances into another 30-year loan, she will be staring at 360 new payments. Lenders won't write a loan with a term of 355 months. That is easily remedied, however, by making a small increase in the monthly payment, sufficient to pay off in 355 months.
Some borrowers are reluctant to refinance a second time because they haven't yet recovered the costs of the previous refinance. For example, one borrower told me that he had paid $4,500 to refinance eight months ago and he wanted to wait 17 months to refinance again because it would take that long for his savings to cover the $4,500.
But the $4,500 is gone and should not affect his current decision. My calculator 3a, which can be used to determine whether or not it pays to refinance now, must be given information about a number of things, including the interest rates on the current and new loans and the points and other costs of the new loan. But the costs incurred on the previous refinance are not there, because they are irrelevant to whether another refinance pays.
Refinancing May Cost More than a Purchase Loan: One would think that if the borrower, property, and loan are the same, a loan used to purchase a home would be priced the same as a refinance. Historically, this was in fact the case. During the prolonged refinance boom in 2000-2003, however, refinancing loans began to be priced higher than purchase loans.
The boom stretched to the limit the capacity of lenders to process loans. Reluctant to add more employees when the boom could fizzle out at any time, lenders preferred to lengthen the processing period and let borrowers queue up for longer periods. But purchasers often have closing dates they must meet and lenders strive to give them priority over refinancers. Pricing refinance a little higher is one way to do this because it cuts the number of refinancers in the queue.
Another factor was at work as well. It costs lenders more to lock the interest rate on refinance loans than on purchase loans. In the past, this was never important enough to cause a difference in pricing, but that also changed during the refinance boom.
If loan applicants who lock always went to closing, over time, lenders would gain as much from rate declines as they lost from rate increases. But in practice borrowers do not always close and the fallout, as it is called, is larger when rates are falling. Some applicants are “lock-jumpers.” They lock and, if rates subsequently decline, they find another loan provider and lock again at a lower rate. Locking thus imposes a net cost on lenders.
This cost is larger on refinancings than on purchases because lock-jumping is more common among refinancers. Borrowers who are refinancing usually are flexible on when they close. Most purchasers, in contrast, must close on a specific date and don't have time to restart the process with another lender.
The prolonged refinance boom increased the number of refinancing lock-jumpers. An unusually large number of borrowers refi-
nanced multiple times within just a few years, learning the ropes in the process. One thing they learned is how to lock-jump. This
widened the difference in lock cost to lenders between refinancings and purchase loans.
Refinancing to Raise Cash: While not all lenders define “cash-out refinance” in the same way, the most widely used definition is that of the two federal secondary market purchasers, Fannie Mae and Freddie Mac. Their rules define a cash-out refinance by exclusion, i.e., they define an ordinary or no-cash-out refinance, and any refinance that does not meet that definition is considered a cash-out.
A non-cash-out refinance is one that a) is used to pay off a first mortgage and/or junior mortgages that were used in their entirety
to buy the subject property, and b) is for an amount not in excess of the loan balance, plus settlement costs, plus 2% of the new loan amount or $2,000, whichever is less. If the borrower has a mortgage balance of $150,000 and settlement costs are $5,000, for example, the loan can be no larger than $157,000.
Any refinance that does not meet these specs is a cash-out refinance and will carry a higher interest rate.
Why Cash-Out Refinancing Carries a Higher Rate: The major reason for the higher rate is that studies of delinquency and default indicate that borrowers who do a cash-out subsequently have poorer payment records than borrowers who don't. The presumed reason for this is that borrowers who need cash are financially weaker than borrowers who don't, and in some cases they may be in financial distress.
Refinancing a Second Is Cash-Out: The agencies assume that refinancing borrowers who want to repay second mortgages that they acquired after they purchased their house are cut from the same cloth as refinancing borrowers who want a large amount of cash. While those refinancing a second don't need cash now, they did need cash when they took a second mortgage. If they were in financial distress then, perhaps they still are. The presumption of distress does not apply, however, if the second mortgage was taken out when the house was purchased.
Loan on a Property with No Mortgage Is Cash-Out: If a homeowner who paid all cash for a property or who has paid off all mortgages elects to take a new mortgage, the agencies consider it cash-out. This is also based on the presumption that the need for cash may signal financial distress.
Portfolio Lenders May Be More Flexible: Lenders who originate loans to hold rather than to sell in the secondary market may be more flexible in their definitions of what constitutes a cash-out. They may not view a loan for the purpose of repaying a second mortgage as cash-out if the borrower has had the loan for some time or if the loan had been used to improve the property. Property improvement might also exempt a loan on a property with no mortgage. Borrowers should be prepared to document the improvements, however.
Cash-Out Versus Second Mortgage: Borrowers who want to raise cash should compare the cost of a cash-out refinance against the cost of a home equity loan. This will depend on the interest rates, points and terms of both loans, the amount of cash required relative to the loan balance, the borrower's tax rate, and other factors.
Calculator 3d on my Web site computes all costs of both options over a future time period specified by the user. It also shows a break-even interest rate on the second mortgage—the highest rate you can pay on the second and come out ahead of the refinance option.
Cash-Out Refinance by Predators: Cash-out refinance is a tool used by some predators to exploit unwary borrowers who are dazzled by the prospect of putting a sizeable amount of money in their pocket. This applies to many of those who have become homeowners with assistance from Habitat for Humanity, who have refinanced the zero interest rate loans provided them by the program into high-rate loans—in order to get cash. See Predatory Lending/Targets of Predators/Cash-Dazzled.
Refinancing with the Current Lender: Borrowers interested in refinancing face the problem of whether they approach their current lender, go to another loan provider, or both. Here are the pros and cons.
The Pros: Perhaps the major reason people approach their current lender is that it is convenient. They are spared having to decide who and where to shop. If their payment record has been good, furthermore, their existing lender has immediate access to their record, where other lenders would have to investigate. There is comfort in “being known” and a belief that this should earn them special treatment.
There is some validity to this belief. The current lender—defined as the firm to which you now remit your payments—may be in a position to offer lower settlement costs than a new lender. How much lower, however, can vary from case to case.
The greatest potential for lower settlement costs arises where the current lender was the originating lender and still owns the loan, a common situation with loans made by banks and savings and loan associations. If the payment record has been good, the current lender may forgo a credit report, property appraisal, title search, and other risk control procedures that are otherwise mandatory on new loans. This is strictly up to the lender.
If the current lender was the original lender but later sold the loan and is now servicing it for the owner, the potential for lower settlement costs is less. A lender servicing for others must follow the guidelines set down by the owner. If the owner is one of the federal secondary market agencies, Fannie Mae or Freddie Mac, the guidelines are theirs. While both agencies have provisions for “streamlined refinancing documentation,” the discretion granted the lender, and therefore the potential cost savings, is quite limited.
The potential for lower settlement costs is least when the current lender is neither the originating lender nor the current owner. This is a fairly common situation that arises when the contract to service the loan is sold. In this case, the lender may not be in a position to use all of the streamlined refinancing procedures because its files do not contain some of the information those procedures require, such as the original appraisal report.
The Cons: The major argument against refinancing with your current lender is that that lender may not give you the market price. It will try to minimize its loss by taking advantage of your preference for staying put and your reluctance to shop the market. Any settlement cost benefits your current lender can offer that other lenders cannot may serve to draw attention away from the fact that the rate and points offered are not competitive.
Above-market offers are especially likely if the lender takes the initiative in soliciting its own customers. Lenders who do that are
likely to base their offer on the borrower's existing rate. For example, in a 5% market, the borrower with a 7% mortgage might be offered 6% while a borrower with a 6% mortgage (but who is otherwise identical) might be offered 5.5%. The objective is to provide a saving over the existing loan that is attractive enough to discourage the borrower from looking elsewhere. This way, the lender gives up as little as possible.
An even greater hazard is that the borrower dealing with the existing lender will get the run around because that lender has no interest in completing the deal. Why rush to convert a 7% loan into a 5.5% loan? I saw one situation where the lender charged an unsuspecting borrower a lock fee and then let him dangle indefinitely.
The Preferred Strategy: In general, the best strategy is to first inquire about the settlement cost savings the existing lender can offer, then find the market price by shopping elsewhere, and then return to the existing lender.
Title Insurance on a Refinance: Borrowers who refinance do not need a new owner's title policy. They must purchase a new policy for the lender, however, because the lender's policy terminates with the repayment of the old mortgage. Such policies are customarily available at a discount, which is usually larger the shorter the period from the previous policy.