Refinancing

Refinancing your home mortgage

Introduction

There are numerous situations where you as a homeowner may consider refinancing as a way to save money. Some of the most common are: (i) replacing a high-interest fixed-rate loan; (ii) refinancing an ARM with a fixed-rate loan; (iii) trading an ARM for another ARM; (iv) getting rid of private mortgage insurance; and (v) combining primary and secondary financing.

Replacing a High Interest Fixed-Rate Loan.

Here, a difference in interest rates of two or three percent makes refinancing viable. Even in cases of smaller differentials in interest rates, refinancing may still be worthwhile, depending on closing costs, how long it takes to recoup them, and how long you expect to remain in the residence. For example, if refinancing results in a $100 savings in monthly payments, and closing and other costs are $4,800, it will take four years to be in the same economic position as before the refinancing. This, of course, doesn't take into account the lost earning power of the $4,800, or the tax consequences. Obviously, if a move within a few years is anticipated, refinancing may be contraindicated.

Refinancing an ARM with a Fixed-Rate Loan.

Although the interest on an adjustable rate mortgage (ARM) will drop if the index used drops, you may figure you are better off locking in a lower rate by refinancing with a fixed-rate mortgage. And consider the reverse situation: If you as an ARM borrower have seen your payments go up each time the adjustment period rolls around, you may want to cut your losses and refinance with a fixed-rate loan, even if fixed rates are higher than your current ARM rate. These decisions are difficult to quantify. You should reexamine how the ARM index has fluctuated over time and build a best-and worse- case payment scenario. The present value of the payments should then be compared with the costs of refinancing.

Trading an ARM for Another ARM.

The first case where you may trade one ARM for another is with a "teaser" ARM. If you bought your home with an ARM with a very low or "teaser" an introductory interest rate, you may be tempted to avoid steeply higher payments at the first adjustment period by refinancing with another "teaser" ARM. This strategy sounds good, but in practice it's tough to make it pay off in significant savings. For example, assume that you bought your home with a $150,000 annually adjustable ARM carrying an introductory rate of six percent. One year later, when the interest rate is scheduled to increase to eight percent, you have an opportunity to refinance with another annually adjustable ARM carrying a five percent introductory rate.

On its face, the three point difference appears to save about $4,500 over one year. But refinancing costs a lot. If the lender is charging two points on the new mortgage, this would $3,000, and then there would likely be other costs that would eat up the savings. Finally, the maneuver merely delays facing the inevitable. One year later, you would have to go through the time, trouble, and expense of another refinancing to keep any savings going. If a "teaser" rate could be found on an ARM with a three-year or
longer guaranteed fixed-rate period, this savings scenario becomes potentially more appealing.

The second reason to refinance an ARM for an ARM might be in a situation where you have an older ARM with a relatively high interest rate floor. For example, let's say you bought a home in 1998 with a $150,000.00, one-year ARM. It is probable that ARMs from that period have a interest rate floor of five percent or higher. In such a case the ARM interest rate will not have gone below the floor of five percent, in spite of the fact that using the ARM calculations it would otherwise have been lower. If you can refinance, lower your initial interest rate, and lower the floor for future adjustments, you would be protected against substantial increases in the interest rate in the longer term future, and be able at the same time to take full advantage of lower-rate adjustments.

If you are inclined toward refinancing with an ARM, you should thoroughly review the various loan products available from your lender. Some ARMs are less volatile than others, owing to the use of more stable indices by which interest rate changes are determined. Also, you will find that there is a much wider variety of indices and ARM options from which to choose today than just a few years ago.

Getting Rid of Private Mortgage Insurance.

Private mortgage insurance, or PMI, which often adds $50 to $200 onto homeowners' monthly mortgage payments, is required by most lenders whenever a borrower obtains a loan with a loan-to-value ratio of less than 80 percent. PMI protects only the lender - or the ultimate buyer of the loan, like Fannie Mae - against financial loss in the event of a borrower's nonpayment of principal and interest. Should a borrower default and the house go to foreclosure, the PMI policy pays the lender's loss to some specified level of coverage and many lenders do not permit the cancellation of PMI.

After considerable action in Congress in recent years, it is now mandatory for a lender to allow termination of PMI at the request of the borrower when certain conditions have been met. Generally, when loan-to-value ration reaches 78% and the loan is in good standing and seasoned, that is one-to-three years old, PMI can be removed at the request of the borrower. It is also mandatory, in most cases, for a lender to automatically remove PMI when the loan has been paid down to 78% of the original amount. Many homeowners who have acquired an equity position in their homes of 20% or more through appreciation or property improvements may be able to remove PMI only through refinancing.

If you refinance to remove PMI, you need to calculate the savings you will experience through removal of the PMI premium and the savings you receive through a lower interest rate to determine whether refinancing is advisable. As a general rule, if you can lower your interest rate by at least one and one-half percent while eliminating PMI, refinancing will be cost-effective.

Combining First & Second Trust Loans.

In recent years, many home buyers have financed their purchases using a combination of primary and secondary financing, or first and second mortgage loans. This has become a very popular alternative to a single mortgage at 90%-95%. In such a case, the buyer would secure an 80% first trust loan and a 10%-15% second trust loan, and thus avoid PMI expenses.

In those instances where equity has grown, through appreciation or improvements, refinancing to combine two loans can be a real money saver. This could even be the case where the secondary financing was not secured in conjunction with the purchase–maybe taken out later as an equity loan to buy a car or for other purposes.

Most secondary financing loans carry a higher interest rate than primary loans. Combining the loans into a single amount with a lower interest rate could save hundreds in monthly payments, and thousands in long-term payments.

Costs of Refinancing

Unless the mortgage has a built-in refinancing option, the closing costs associated with refinancing are almost the same as those charged on an original mortgage; however, most items which are deductible for Federal and State income tax purposes on a purchase are not immediately deductible on refinancing. A list of the most common costs of refinancing follows:

Points: Rarely seen anymore, but when used, usually called loan origination or discount fees, one point equals one percent of the loan amount. Points often are the biggest expense in refinancing. If the payment of points is only for the use of money and not for any specific services, it is interest paid in advance and under the Internal Revenue Code a tax-deduction is available, when the debt is secured by one's residence. If refinancing is for current improvements, certain educational expenses or medical expenses, the points may be deductible in the year in which paid, otherwise they may be deducted over the life of the loan. Finally, Where points clearly will not be deductible, instead of paying them out of pocket, you may want to consider financing them by adding them to the amount borrowed. Your deduction of the points could then more closely match your costs in paying them during the term of the mortgage.
Application fee: Some lenders charge a non-refundable fee that is paid up front and is not returned even if the loan is denied. The fee, which may run to several hundred dollars, may encompass an appraisal of the home and a credit check.
Survey: A lender may require a new property survey or a survey update or re-certification; however, most lenders accept an affidavit from you as the homeowner that there has been no change to the property improvements or boundary since the last survey. A new survey will cost approximately $250-$750, while a re-certification or an update will cost $175-$250, if one is needed.
Title insurance: Despite the fact that the property is not changing hands, the lender will require a new mortgagee title insurance policy for the new loan. Refinancing loan policies cost 70% of the original issue loan rate, beginning at $2.03 per $1,000 of coverage up to $500,000.
State and local recording taxes: These are nondeductible taxes. The amount depends on the size of the mortgage. In Virginia, the combined State and local tax is $3.34 for each $1,000 of the new mortgage. If refinancing an existing mortgage loan, regardless of the balance, you are taxed at the reduced combined rate of $2.40 per $1,000 of the new mortgage.
Attorney's fees: You must pay attorney's fees, or a closing fee to the settlement agent conducting the closing on the new loan. This will generally be a few hundred dollars.
Prepayment penalty: The existing mortgage and applicable law must be checked for a prepayment penalty. If there is one, it may be deductible for income-tax purposes if it takes the form of an interest penalty.
Cost of repaying secondary financing: If you carry a first mortgage and a second mortgage or home-equity line of credit, a lender refinancing the first mortgage may require you to pay off all secondary financing. In many cases, depending on the type of loan sought, lenders will accept a subordination agreement whereby the secondary financing stays in place but is subordinated to the new first mortgage. If the secondary financing must be paid off, it could cause a temporary cash flow problem, and the costs to re-establish a home equity credit line or subordinate the secondary financing must be considered as part of the refinancing costs. These costs usually do not exceed $200-$300. If you intend to keep secondary or equity financing in place, check with your equity lender regarding its procedures and time requirements for subordinating its loan to your new first mortgage. Some equity lenders charge a fee to subordinate their interest, so check that as well.
Miscellaneous costs: The lender may require certain inspections of the property, such as an update of the termite inspection, inspection of a well and septic system, or a flood-zone certification; interest on the new loan is usually collected at closing from the date the loan is funded to the end of the month; and, there may be other costs, such as courier charges, title commitment fees and title abstracting costs.

Closing costs, including points, can amount to as much as five percent or more of the loan itself. However, to the extent that the costs are tax-deductible, the burden is eased somewhat. Nondeductible items generally increase your tax basis in the home and thus may reduce gain on ultimate disposition or resale.

Loan Processing Time

It can take as much as 60 days from application to secure a loan commitment and 60 to 120 days from application to closing. These time frames are only averages and actual time may vary widely among lenders and settlement agents. Another timing factor is the question of when you lock into a particular rate. Some lenders lock in the rate upon commitment, others not until the closing. Some lenders lock in the rate upon application for a set period. Some give borrowers the option of locking in the rate prior to closing by paying a fee, such as an additional point or half point added to the refinancing costs.

Time to Recoup Costs

When calculating the actual costs of refinancing, remember to consider the fact that you will probably miss at least one payment on either the old or new loan as part of the refinancing. This occurs because you will pay interest on the old loan as part of the payoff and will not make your first payment on the new loan until the first day of the first full month following closing on the new loan. Also, when calculating the actual costs of refinancing, consider that even though you may pay money at closing to start new escrow accounts, you will be refunded the balance in old escrow accounts from your old loan. There is usually a net expense of one additional month of escrow deposits as part of refinancing - to cover the month for which you will not make a payment on either loan. Arguably, however, escrow deposits should not be considered when determining your actual costs of refinancing. In either event, you should check with the new lender about the possibility of waiving the escrow deposit requirement if you desire to pay the escrow items (e.g., taxes and insurance) directly.

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Potomac West Title

Refinancing your home mortgage

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