December 5, 2008 in Mortgages

How does refinancing a home work?

Mortgage refinancing activity has surged in recent days as homebuyers rush to take advantage of suddenly plummeting loan rates.

The frenzy to find a new loan began when mortgage rates suddenly dropped in the wake of the Federal Reserve’s Nov. 25 announcement that it will buy up to $500 billion of securitized loans.

The rate drop helped fuel a whopping 203.3 percent increase in refinancing activity for the week ending Nov. 28, according to the Mortgage Bankers Association.

To help homeowners make the right refinancing choices, Bankrate asked personal finance expert Dr. Don Taylor to answer some frequently asked questions about the process.

6 key refinancing questions

  1. Does my new rate have to be at least 2 points lower?
  2. Is it cheaper to refinance with my current lender?
  3. Is it common for mortgage brokers to get a “finder’s fee”?
  4. What’s the difference between the rate and the APR?
  5. Does a cash-out refinance to complete home projects make sense?
  6. Should I refinance to pay off an auto loan?<

1. Does my new rate have to be at least 2 points lower?

No. You don’t have to wait until mortgage interest rates drop by 2 percent before you consider refinancing your mortgage.

The decision to refinance your home is dependent on many things, including how long you plan to be in the house, how much lower the interest rate will be on your new loan, the closing costs for the new loan, your equity position in the home and whether you plan to do a cash-out refinancing.

With a plain-vanilla refinancing, you’re trying to take advantage of lower interest rates to lower your monthly payments. If you have enough equity in your home, you may even have a side benefit of being able to stop paying private mortgage insurance, more commonly known as PMI.

To take advantage of a lower rate you’ll have to close on a new loan and pay the closing costs associated with that loan. That’s true even if you opt for a no-cash or low-cash closing. With a no-cash or low-cash closing, the costs still are there, they just are paid for either with a higher interest rate or are included in the principal balance of the loan. (There’s truly no such thing as a free lunch.)

If you don’t plan on being in the house very long, then the lower payments associated with the refinancing won’t cover these closing costs. Bankrate’s refinancing calculator will help you estimate your new mortgage payment, closing costs, and the months that it will take you to recoup those closing costs.

The table below shows an example of how the numbers work for someone with an existing 8 percent mortgage. It makes clear why you may not want to refinance for a rate only half a percent lower, but how reducing your rate by a full percent or more has a fairly short payback.

Refinancing example

Loan maturity (years): 28 30 30 30 30 30
Interest rate: 8% 7.5% 7% 6.5% 6% 5.5%
Monthly payment: $1,100.65 $1,039.30 $988.89 $939.49 $891.16 $843.95
Total payments: $369,818 $374,147 $356,001 $338,217 $320,817 $320,817
Total interest expense: $221,180 $225,509 $207,363 $189,580 $172,180 $155,184
Estimated closing costs: 0 $2,500 $2,500 $2,500 $2,500 $2,500
Payment savings: 0 $61.35 $111.75 $161.15 $209.49 $256.70
Months to recoup: 0 41 23 16 12 10

Don’t worry about the points you paid at closing on your current loan when you’re considering a refinancing. (See “IRS Topic 504 — Home Mortgage Points” for tax implications.) They aren’t relevant to the analysis because they’re sunk costs.

Look instead at what you can save going forward. Compare APRs when deciding between loans. You may be able to refinance with your current lender and pay less in closing costs, but you need to be sure that its rate is competitive.

As always, you can shop rates in your market on Bankrate. (Bankrate even provides an APR estimate.)

You’d rather refinance once and lower your interest rate by a point or more than do multiple refinancing for smaller interest rate savings. Keep your pulse on where rates are and where they’re going by reading the Mortgage Rate Trend Index every Thursday on Bankrate.

2. Is it cheaper to refinance with my current lender?

It just seems logical that it would be easier and less expensive for your existing lender to refinance your home. After all, the lender knows both your payment history and the property.

The lender may not need a new property appraisal, a title search or other items that would normally be required on a new loan. The lender should also be willing to offer a better price because it’s easier to keep a good customer than it is to find a new one.

The holy grail of refinancing is when the lender just reduces your interest rate and doesn’t require you to close on a new loan. This can only happen if you are just rolling your existing balance and aren’t looking for a cash-out refinancing.

So, why doesn’t it happen more often? The problem is that the mortgage market is divided into three lines of business: mortgage origination, mortgage servicing and mortgage lending.

If the firm that originated your existing mortgage didn’t retain the servicing, you aren’t a current customer. If the firm servicing the mortgage doesn’t do originations in your market, then they may not be interested in your business.

Finally, mortgage investors are looking for packaged or securitized mortgages that are part of a pool of mortgages, so they aren’t interested in your stand-alone business.

Ask your current servicing provider what cost savings they offer to current customers who refinance with them. You also need to find out what terms competing lenders offer.

Saving a few hundred dollars in closing costs doesn’t mean much if you can get a lower interest rate from another lender. Shop rates on Bankrate.com before talking to your current servicing provider, so you will be able to recognize a good deal and use Bankrate’s refinancing calculator to determine your refinancing savings.

If you are going to apply at several lenders, you should do it within a 30-day period. Your credit score won’t be hurt by comparison shopping for a mortgage if you concentrate your applications within this time frame.

That’s because Fair Isaac Corp. (the company that works with the credit reporting agencies to provide your credit score to lenders) considers these multiple mortgage inquiries as one inquiry when calculating your credit score.

3. Is it common for a mortgage broker to get a “finder’s fee?

A finder’s fee, paid to the mortgage broker by the originating lender, is just one way that a mortgage broker can be compensated for arranging your refinancing.

A mortgage broker is an intermediary between you and the lender. Like most middlemen, they add a markup to the wholesale cost, and then you pay the retail rate.

There’s nothing wrong with this arrangement as long as the mortgage broker doesn’t cut corners to increase his profit margins and provided that he hasn’t priced a huge markup in his services.

Bankrate’s feature on using a mortgage broker can help you understand how to manage this process. A typical starting point for a mortgage broker is to charge you one point (1 percent of the loan amount) for his services. You may also have to pay an application fee.

Most mortgage brokers don’t reveal their compensation until required to by law — when the loan application has been submitted. The amount of fees and charges that you pay in connection with your loan will be provided on the Good Faith Estimate that the mortgage broker is required to provide you under the Real Estate Settlement Procedures Act.

This disclosure is only an estimate. The final amount will be disclosed on your HUD-1 or HUD-1A Settlement Statement. You are entitled under RESPA to request and receive a copy of the Settlement Statement, with actual closing costs, one day prior to closing.

This is helpful information, but it comes a little too late to help you in comparison shopping or negotiating with mortgage brokers or lenders. A better way to compare lending programs is to use the FTC’s online brochure “Looking for the Best Mortgage.”

The advantage to using a mortgage broker is that the broker can shop multiple lenders. Mortgage brokers are not miracle workers and can’t make someone with a bad credit history magically qualify for a low interest loan. Think of them more as personal shoppers who is helping you find a loan that’s right for you.

One good way of keeping your broker honest is to shop rates in your local market using Bankrate. Bankrate’s mortgage search feature will provide you with mortgage rates, points and annual percentage rates on loans and can be invaluable in understanding the mortgage market in your community.

If you want to negotiate your best deal with a mortgage broker, you should spend the time and money to know your credit score, review your credit report for errors and correct any errors on your report.

To get a low interest rate, you will need to put your best foot forward. Knowing your credit score will help you understand whether you’ll qualify for a lender’s best rates. All three consumer reporting agencies can provide you with a credit score along with a credit report.

4. What is the difference between the rate and the APR?

The annual percentage rate adjusts the mortgage interest rate to reflect estimated closing costs, including points paid at closing and mortgage insurance.

The Truth in Lending Act requires lenders to provide the APR when advertising a mortgage loan and provide prospective borrowers with the loan’s APR upon request. APRs aren’t perfect, since closing costs are estimated and the lender can round off by up to a quarter-percent.

In general, neither the lender nor anyone else may charge you a fee until you have received this information. The Federal Trade Commission has a mortgage shopping work sheet that can help you lay out the costs associated with several loans and identify the loan that is best for you.

Bankrate also provides you with an estimate of a loan’s APR when you search for mortgage loan rates.

With so much refinancing taking place, you need to have confidence that your lender will be able to complete your loan origination in a timely and efficient manner. Ask the lender for references, and check them out with the Better Business Bureau.

5. Does a cash-out refinance for home projects make sense?

First, find out whether you’d end up with both a lower monthly payment and a shorter loan term. If your credit is good and the house appraises well — no sure thing with today’s falling home prices — refinancing may be a slam-dunk.

For example, let’s say a consumer can go from a 9 percent loan to around 5.25 percent on a 15-year fixed-rate loan. The borrower would end up with lower monthly payments and a shorter loan term. Refinancing is a great choice.

Does it make sense to refinance?

  Existing loan Refinancing Difference
Loan balance: $99,000 $99,000  
Interest rate: 9% 5.25%  
Loan term (months): 210 180  
Payment: $937.77 $795.84 $141.93
Total payments: $196,932 $143,251  
Total interest expense: $143,251 $44,251 $53,681

You can use Bankrate’s mortgage calculator to create your own table using the actual balances, interest rates and loan terms. Even if you have to pay a few thousand dollars to close on the new loan, the interest savings combined with the shorter loan term provide a great incentive to refinance. Bankrate’s refinancing calculator will estimate how long it will take to recoup your closing costs given the lower mortgage payment.

Does it make sense to spend money on home improvements? If you accept that you’re not going to get back every dollar you put into the house and that the benefit you get from the improvement is what balances out the equation, then it may make sense to remodel or renovate your property.

The following table takes a look at the cost of doing a cash-out refinancing for $20,000. It ignores the closing costs associated with the financing. You’d have a monthly payment about the same as you have now on your mortgage but you’d be able to finance $20,000 in improvements and still have the loan paid off 2.5 years before your original mortgage.

The cost of cash-out refinancing

  Refinancing Cash-out refinancing Difference
Loan balance: $99,000 $119,000 $20,000
Interest rate: 5.25% 5.25%  
Loan term (months): 180 180  
Payment: $795,84 $956.61 $160.78
Total payments: $143,251 $172,191 $28,940
Total interest expense: $44,251 $53,191 $8,940

Assuming your home hasn’t lost too much value in recent years, and depending on the cost of your projects, you should be able to do a cash-out refinancing without paying private mortgage insurance (PMI) on the loan. If the loan-to-value on the cash-out refinancing will be over 80 percent, you should consider other financing options before deciding how you’ll finance the home improvements.

6. Should I refinance to pay off an auto loan?

Restructuring your debt load to pay off your car loan with mortgage debt can make sense if: (1) you can use the mortgage interest deduction on your taxes; (2) the after-tax rate on the mortgage loan is less than the interest rate on the car loan; (3) there isn’t a prepayment penalty on the car loan; and (4) you have sufficient equity in your home that borrowing the additional $27,000 won’t cause you to pay private mortgage insurance on the mortgage debt.

There are some drawbacks. Paying off your car over 15 to 30 years will negate any savings from a lower interest rate, not to mention the debt hangover you’ll have when you go to buy your next car and you’re still paying off the old one.

Both auto loans and car loans are secured loans. If you don’t make your car payment, the lender can have your car repossessed, but if you don’t make your mortgage payments the lender can foreclose on your home.

When deliberating about whether to take this step, look at the refinancing as a stand-alone decision. Does it make sense to refinance to capture an interest rate 1.25 percent lower than your current mortgage? It may not if you only plan on being in the house for a few years and closing costs are expensive.

Bankrate’s refinancing calculator will help you determine how long it will take you to recoup your closing costs from the lower monthly mortgage payment.