Essentials of Refinancing a Mortgage
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The current low-interest rate market has created extraordinarily attractive opportunities for refinancing. Some borrowers, however, will make better use of the opportunity than others. This article sets out what a borrower needs to know to make the right decisions on whether to refinance, how to refinance, where to refinance, and how to remedy a poor choice by rescinding a refinance.
Refinancing Criteria
The obvious criteria is the interest rate the applicant can find in the market relative to the rate on her existing mortgage. This is complicated, however, by refinancing costs which are out-of-pocket unless the applicant has the lender pay them, in which case the new interest rate will be higher than it would have been otherwise. Such lender payments are termed “premiums”.
Premiums are the opposite of “points”, which are payments made by the borrower on top of other refinance costs, in exchange for a lower interest rate.
The best way to select from different price quotes involving both rates and points is to compare total costs over a future period that is applicants’ best guess of how long they will have the new mortgage. This is the method used by my Calculator 3a.
A second-best approach that does not require a calculator is to shop for the lowest interest rate at specified points or premiums. Employing this approach, here are some useful rules of thumb:
- If the applicant expects to sell her house within 4 years, she wants a “no-cost” loan, meaning one that carries a premium large enough to pay all the refinance costs. The alternative of paying cash to cover refinance costs might appeal to a borrower who wants to minimize the monthly mortgage payment.
- If the applicant expects to be in her house 6 years or longer, liquidating low-yield assets in order to pay rate-reducing points is a prudent investment.
Refinancing Two Mortgages
An applicant with two mortgages needs to compare the total cost of retaining the two existing mortgages over her time horizon with the cost of refinancing into one or two new mortgages over the same period. While there are no simple rules of thumb for doing that, my Calculator 3b does it and is simple enough.
Refinancing With Cash-Out
Borrowers who want to extract cash from their refinance should expect to pay a higher price. The reason is that borrowers who extract cash have poorer payment records than borrowers who don’t.
An annoying complication, however, is that the definition of cash-out is broader than the extraction of cash. Any refinance that occurs within 12 months of a previous cash-out refinance, or within 12 months of a second mortgage that was not part of the home purchase, is also considered cash-out and priced accordingly. If either of these contingencies apply, the borrower might want to wait until the 12-month period has elapsed.
Financing Closing Costs
Borrowers who are short of cash can include the closing costs in the loan balance without the transaction becoming “cash out”. In fact, the rule allows the borrow to finance the costs plus the lower of $2,000 and 2% of the loan amount.
Refinancing With Cash-In
Cash-in refinancing is the opposite of cash-out refinancing in that the borrower pays down the balance as part of the transaction. The purpose is to reduce the mortgage price and/or the mortgage insurance premium by increasing the borrower’s equity in the house.
Borrowers with an existing loan balance that exceeds 80% of equity might find this an attractive investment in a market in which alternative investments carry very low yields. The rate of return on a cash-in refinance that is comparable to the rate on investments can be obtained from my Calculator 3f.
Refinancing With Current Lender
The case for refinancing with your existing lender is that, under some circumstances, the lender can refinance you with minimal settlement costs. The lender may forgo a credit report, property appraisal, title search and other risk control procedures that are otherwise mandatory on new loans.
Indeed, if you are looking only to reduce the interest rate, and not to take any cash out of the transaction, and if your payment record has been good, your existing lender may elect simply to reduce the interest rate on your current loan rather than refinance it. This replaces all settlement costs with a small fee for amending the contract.
Unfortunately, however, the separation of loan origination and loan servicing functions has largely eliminated these options. Firms servicing loans owned by others (including Fannie Mae FNMA and Freddie Mac) must follow the rules stipulated by the owners, and these rules never allow the servicer to adjust the rate on an existing loan. The only lenders with this flexibility are the few who service the loans that they own.
There is one other deterrent to borrowing from the existing lender. The rule granting applicants an option to rescind does not apply to transactions with the borrower’s existing lender.
Bottom line, borrowers are best served by shopping the market, taking advantage of internet-based sites on which lenders compete.
Avoiding Discrimination
I have never met a mortgage loan officer or broker who would relinquish the commission on a loan in order to reject an applicant on the basis of race. Applicants who question that can protect themselves by shopping at internet sites on which they can qualify themselves and price their mortgage without disclosing their race.
It would be extremely difficult for a lender receiving a lead from an internet site to reject the deal after the applicant has entered the application phase and discloses her race. The lender would be required to document the reasons for a rejection. If instead, the lender changes the price so that it no longer conforms to the price on the site, a refinancing applicant can rescind the deal, converting it into a loser for the lender.
Right of Rescission
Under the Federal Truth in Lending Act, borrowers who refinance a loan on their primary residence with a lender other than their current lender can cancel the deal at no cost to themselves within 3 days of closing. This “right of rescission“ can be valuable protection for borrowers who realize they have made a mistake, or suspect that the lender has abused them in some way.
Here are some details that will be useful to anyone considering a rescission:
- To exercise your right, send a letter of rescission registered mail with return of receipt requested. This will avoid the possibility that the lender places your letter in the shredder and claims it was never received.
- Within 20 calendar days of receipt of your letter, the lender is obliged to return any payments you have made to anyone in connection with the transaction.
- If your closing documents do not include a written statement of your right to rescind, you get three years to rescind instead of 3 days.
For a variety of reasons, most borrowers who decide their refinance was a mistake don’t realize it for weeks or months after the closing. For the borrower three days is not enough, but an extension would impose major costs on lenders, as well as on borrowers who have no need for an extension. The moral is that borrowers who feel uneasy about their refinance should check it out with an expert within the 3-day period.