Editor’s note: This is the first of a multipart series.
This series of articles is about opportunities available to consumers to save money on an existing mortgage, or on a new one they plan to take in the near future. This one is about unexploited refinance opportunities.
Interest rates have been at historically low levels for some time now and some borrowers have refinanced two or three times, but there are others who so far have allowed the opportunity to pass them by. I am not referring to borrowers who can’t possibly meet today’s standards. They haven’t refinanced because they can’t. My focus is on those who can refinance profitably but don’t for a variety of reasons.
Erroneous beliefs: The following beliefs that prevent or discourage refinancing have been related to me by borrowers. All are false:
- Borrowers have to wait some minimum period after taking a mortgage before they can refinance.
- The borrower who refinances loses the benefit of principal payments already made.
- The borrower who paid points to reduce the interest rate on the current mortgage should wait until such time as the interest savings have at least covered the cost of the points.
- The borrower who has had a mortgage for a long time has to begin the process from scratch, delaying the period until they are out of debt.
- It is better for a borrower who has been making extra payments to continue that practice, rather than refinance.
Readers will find explanations of why these notions are wrong on my website at "Valid and invalid reasons for not refinancing."
Unrealistic fear of adjustable-rate mortgages (ARMs): There are borrowers with fixed-rate mortgages (FRMs) who would not profit from refinancing into another FRM, but who would profit from refinancing into a lower-rate ARM — but they don’t because of fear of a possible future ARM rate increase. In many cases, this fear is not justified because the borrower can pay off the loan within the initial fixed rate period on the ARM, which can be five, seven or 10 years.
To execute this strategy, the borrower must have the capacity to make payments larger than the required payment on the ARM. There is always a payment large enough to pay off the loan fully within the initial ARM rate period, the question being the borrower’s capacity to make that payment. The previous payment on the FRM might be large enough to do the trick, or it might not.
Even if the borrower can’t pay off completely within the initial rate period, paying a higher rate for a few years on a much reduced balance will not come close to wiping out the interest savings during the preceding years.
For more on this topic, read "Refinancing from FRMs into ARMs."
Failure to exploit a profitable investment opportunity: Many mortgage borrowers can’t refinance profitably, or think they can’t, because their house has declined in value and a refinance would require the purchase of mortgage insurance, which they don’t have now. However, if they have investment assets that can be liquidated to pay down their mortgage balance, the rate of return on investment will be far higher than the return they are earning on those assets now. This is called "cash-in refinancing" because the borrower is putting cash into the transaction, as opposed to cash-out refinancing where the borrower withdraws cash.
Here is an example: John has a 6 percent mortgage with 300 months to go and a $100,000 balance, but his house is worth only $100,000, which makes him ineligible for a refinance. However, if he pays down the balance to $80,000, he can refinance into a 4.5 percent loan with closing costs of 2 percent. If he stays in the house for five years, the rate of return on his investment, consisting of $20,000 in balance paydown plus $1,600 in closing costs, would be 9.98 percent. The return is riskless to the borrower.
The return on investment can be calculated using Mortgage Cash-in Refinance Calculator 3f on my site.
Rejected and gave up: Some borrowers have not refinanced because they tried and were rejected, and then gave up. But not all rejections are created equal — depending on the reason, some deficiencies are fixable. Here are a few:
- You met the underwriting standards of the federal agencies (Fannie Mae, Freddie Mac, FHA) but not those of the particular lender who rejected you. Some lenders have "overlays" that impose more restrictive requirements than those of the agencies, and where this is the case, you might well be approved by going to another lender.
- You were rejected because your credit score was too low for reasons that are quickly remediable. Examples would be scores lowered by a reporting mistake, or by credit card balances that are large relative to the maximums.
- You were rejected because your equity in the property was too small based on a faulty appraisal. A new appraisal obtained through a different lender could provide a different outcome.
- You were rejected because your debt-to-income ratio was too high and you have the means to reduce it – for example, by borrowing against a 401(k) in order to pay down other debt.
For more on this topic, see "Refinance rejection: Can anything be done?"
Next week: Saving money on a new loan.
The writer is professor of finance emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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