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Monday, January 12, 2015

does refinancing make sense even if you're rate isn't lower?

"The only 2 quotes I can make with emphasis are: 1.) Don't refinance out of desperation, unless you're also fixing the underlying problem which brought you to panic-mode in the first place, and 2.) These days you're probably going to win if you can get out of your FHA loan."
The art of the refinance...

"When is it a good idea to refinance?" is a question I hear fairly often. Other variations include "how much lower does my interest rate need to be?" and "how much lower does my monthly payment have to be for it to make sense?"

Unfortunately there isn't a magic number or percentage point that triggers a refinancing win. There are other factors involved than just rate and savings, like how long you're going to have that mortgage, how long you're going to stay in that house, what you're going to do with the monthly savings, and how far away you are from retirement, just to name a few.

Everybody's situation is different, and a refinance that's right for one person might not be a good idea for the guy next door.

One rule of thumb that seems to make sense these days, however, is if you can get out of an FHA loan, then do it - FHA loans carry very expensive mortgage insurance rates, and they require you to keep the mortgage insurance for far longer than is sometimes necessary.

Let's look at a recent example I know of. There will be a lot of math involved, so I'll keep it as simple as I can. But I'll also explore some of the soft costs and benefits - the "art" of the refinance.

* Note - the exact numbers and details below have been changed for privacy considerations.

Our homeowner bought a home in 2013 for $200,000 with a smoking hot 3.875% interest rate on an FHA loan with 3% down payment, and has made 20 mortgage payments since then.

Should this homeowner pursue a refinance?

Let's start by writing down the specific numbers from when he bought the house.

  • Purchase Price: $200,000
  • Down Payment (3%): $6,000
  • Orig Loan Amount: $194,000
  • FHA One Time MIP (1.75%): $3,395
  • Final Loan Amount: $197,395
  • Interest Rate: 3.875%
  • Loan Term: 30 years
  • P & I Loan Payment: $928
  • Tax & Insurance: $225 (give or take)
  • FHA MMI Monthly Mortgage Ins (1.35%): $288
  • PITII Total Loan Payment: $1,441
  • Loan Balance after 20 months: $191,087
  • Value of home today, 20 months later: $225,000 (12% appreciation in the last 1.5 years sounds reasonable.)

Now let's look at the hard facts and costs about the refinance he's pursuing.

  • Out of Pocket Costs: $500 for appraisal and credit report
  • Costs and Expenses Added to Loan Balance*: $5,500

* There are some costs involved in a refinance, such as lender processing fees and title insurance fees.

* There are also cash flow changes as you pay off one loan and write a new one - they aren't really expenses because you'll pay them one way or the other, but they need to be understood and accounted for. These include interest charges (which is why you skip a monthly payment when you refi) and taxes & insurance collected to set up a new escrow account. You don't actually pay extra taxes or insurance, but the new escrow account requires an upfront balance.

Let's look at our borrower's new loan.

  • New Loan Balance: $196,587 (prior balance of $191,087 + increase of $5,500)
  • New Loan Interest Rate: 4.375% (yes, that's 1/2 % higher than his current rate.)
  • New Loan Term: 30 years
  • P & I New Loan Payment: $982 (it's actually $54 higher.)
  • Tax and Insurance: $225 (no change)
  • Private Mortgage Insurance: $98 (assuming 0.6% rate on a 90% LTV Conventional FNMA mortgage)
  • PITII Total New Loan Payment: $1,305
  • New Loan Monthly Savings: $136

Is this a good idea? First let's look at the numbers.

Wow (said sarcastically) - all that to save $136 per month.

Let's see. You spent $500 out of pocket. you added $5,500 to your mortgage balance, and you added 21 months to the length of your mortgage ($1,305 * 21 months = $27,400), in order to save $136.

$27,400 extra months' payments + $5,500 increased mortgage balance + $500 out of pocket costs = $32,400 total costs.

$34,300 total costs / $136 savings per month = 252 months to break even.

That awesome. (more sarcasm.) 252 months from now you will reap the benefits from this refinance, right?

Wrong, because we haven't looked at the whole picture yet.

Let's take into consideration what happens to those "soft costs and expenses" - part of the $5,500 that was added to the loan balance.

Our borrower is closing on his refinance before the 15th of the month, which means he didn't need to make this month's mortgage payment. He saved $1,441 this month.

And, because mortgage interest is paid in arrears (you accrue it first and then pay it second), he won't have a mortgage payment next month, either. There's another $1,441 saved.

Our borrower will keep $500 out of this $2,882 in his pocket, to repay himself for the appraisal fee. He will send the remaining $2,382 to his new mortgage as a principal reduction payment.

Sometime in the next 60 days our borrower will receive a refund from his old mortgage's impound account for taxes and insurance money that was collected but unused - let's assume $400. Our borrower will send this $400 in as another principal reduction payment.

Benefit # 1

Now the new mortgage balance is $193,805, which is only $2,718 higher than his current balance, and he has recovered the $500 out of pocket expenses. So, with a monthly savings of $136, he'll break even in about a year and a half. Everything after that is pure savings.

Benefit #2

Because he put the extra $2,782 back into the mortgage as a principal reduction, each payment he makes will now include a little less interest and a little more principal, such that the loan will be paid off in 349 months instead of the traditional 360.

Sure, he will still have 9 more months under the new schedule at $982 per month (taxes and insurance will be required with or without a mortgage, and mortgage insurance will have been long since removed from the loan.) $982 * 9 months equals $8,838 in extra mortgage payments.

Compare that against saving $136 for the next 6 years or so, assuming mortgage insurance will drop off at some point in the future. $136 * 72 months equals $9,792. Let's call that a wash.

But all of this is based on him keeping the home, and the mortgage, for the next 30 years. The current mortgage only gets a benefit if he does so. If he ends up moving, or refinancing again, or paying the mortgage off earlier, then the new refinance gets the benefit.

Benefit #3

Conventional mortgages will drop the PMI requirement once the borrower has 20% equity in the house. (LTV < 80%). So, after a couple-few years of appreciation, the borrower will have to pay for an appraisal review and then automagically start saving another $98 per month.

FHA mortgages can hold onto their MMI for a much longer time period, and even once the borrower has more equity in the home he might be required to refinance to get rid of the FHA MMI, which doesn't help at all if interest rates have risen significantly by that time. Care to guess where rates are going to be in 3-5 years? (hint - they can't really be any lower..)

Based on the numbers alone I'd say the refinance is a good idea.

Concern #1

If the borrower doesn't put the extra cash flow back into the mortgage, then the picture changes entirely. At that point he's just used his home as an ATM machine, which common sense (and history) tells us isn't always the best idea. Maybe it's still worthwhile; maybe not, but the equation needs to be reworked and the decision needs to be made on its own merits.

Concern #2

If the borrower loses his job or has some other catastrophic event happen within the next month or two which requires selling the home, he has less equity in the home which could be used for price flexibility and/or cash available after the sale. This is obviously not very likely, but we can't pretend it doesn't exist.

Conclusion

The math behind a refinance decision is pretty straight forward, provided you look at the entire picture and include all the cash flows involved.

The art behind a refinance can be much murkier, as each homeowner has to come to grips with questions about the future. What might be a good idea for one person may not be for the next.

The only 2 points I can make with emphasis are: 1.) Don't refinance out of desperation, unless you're also fixing the underlying problem which brought you to panic-mode in the first place, and 2.) These days you're probably going to win if you can get out of your FHA loan.

Other than those, go ahead and weigh the options, think long and hard about it, and then make the decision that makes the most sense.

-Chris Butterworth

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