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:
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
The following chart indicates how many months it would take to recoup specified dollar amounts of refinancing costs for specified
decreases in monthly payments.
To use the chart, look across the top of the chart for the number which most closely approximates the expected decrease in monthly
payment that would result from a proposed refinancing. Next, at the column on the left, locate the dollar amount that is closest to the
actual costs of refinancing. Now find the number in the intersecting box. This is the approximate number of months it will take to
recoup the costs of refinancing.
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.
Use the following loan calculator to determine your monthly payment for various terms and interest rates.
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
9316-A Old Keene Mill Road
Burke, Virginia 22015-4285
703-584-7744 (F) 703-584-7746
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9316-A Old Keene Mill Road
Burke, Virginia 22015-4285