The beauty of an economic downturn is cheap credit. It’s ironic,
because cheap credit is one of the main causes of this collapse in the
first place! That said, for those of you with mortgage debt, now is a
great time to call your local bank and check up on rates. Refinancing
can be a daunting process, but it shouldn’t be with the right
representative and proper frame of mind.
I recently refinanced one of my rental properties and now is a good
time to share with you some key things to think about and assess.
Hopefully by the end of this article you will be able to make an
informed decision and save lots of money as a result!
INFLATION
Knowing when to refinance is like being a bond trader. Bond traders
obsess over inflation assumptions, and you should have at least a basic
assumption as well. Clearly, there has been tremendous monetary
expansion recently, which should ultimately lead to higher inflation.
Basic economic theory says that for every new $1 dollar bill printed,
there will be a $1 increase in prices in the overall basket of goods
eventually. The key word is eventually, which could be decades away.
People have been waiting for higher inflation, and therefore higher
rates for the past decade. Ironically, those with short-term fixed
mortgages (ARMs) are this century’s winners, because rates are resetting
at equal to lower levels than when they were originally fixed!
Inflation has been coming down now for over 25 years, and I see
little reason to expect inflation to suddenly jump higher given the
tremendous output gap in the economy. If inflation does start rising,
at least you know that your assets are by definition also rising in
nominal value.
The figure to watch is the
10-year US treasury yield. Currently at
3.4% 2% 1.6%
(as of 6/22/12) the yield is hovering close to the lows of the past
decade. Meanwhile spreads between treasury yields and bank mortgage
rates have narrowed since the crisis. Most long term duration mortgages
are related to the 10-yr bond yield, hence whenever you see the stock
market crashing,watch bond prices rise, and yields fall. This is the
exact time to call your mortgage broker.
DURATION
Now that you have made an assumption on inflation, you should consider matching your fixed rate duration with the time you plan to hold or pay off the loan.
For example, if you plan to hold onto your property forever, but need
as long a time to pay off the mortgage as possible, it behooves you to
take out a 30-year fixed mortgage. Your base case scenario is that in
30 years, you will pay off your mortgage in full, but I suggest you pay
extra when you can to save on long term interest costs.
On the other hand, if you plan to only keep your property for 5
years, or plan to pay off the mortgage in 5 years, it makes more sense
to take out a 5/1 ARM (adjustable rate mortgage), especially if you
think inflation stays benign.
Given the yield curve is upward sloping, longer
duration loans have higher interest rates. This is a tautology for the
most part, except during times of extreme economic duress, where the
yield curve flattens, or inverts given people want their money as liquid
as possible. Assuming a normal upward sloping yield curve, you will
pay a higher rate for a longer duration mortgage.
Current 30-yr conforming mortgage rates are roughly
4.75%-5.25% 4.25%, 3.875% while 5/1 ARMs (5 years fixed and floating thereafter) are at
4-4.25% 3.125% 2.625% as of 6/25/2012. This is why I encourage all of you to
check for the latest mortgage quote on your property for free if you have not done so in the best 6 months. Rates have continued to go lower and you will save a lot of money!
REFINANCING COSTS
The are a bunch of costs that go into refinancing which unfortunately
eat into the savings of refinancing. The way to think about costs is
to get the total cost of refinancing divided by the monthly savings of refinancing to see how many months it takes to break even.
For example, let’s say it costs $3,000 to refinance a $400,000 loan
from 5.25% to 4.25%. Your monthly payment goes from $2,375 down to
$2,135 for a savings of $240. Take the $3,000 in refinancing costs
divided by $240 = 12.5. In other words, it takes 12.5 months for you to
start benefiting from a refinance.
If you plan to take 360 months (30 yr fixed) to pay off your
mortgage, your actually savings would be $83,400 (347 months X $240)
making the $3,000 cost to refinance a no-brainer. Ironically, you save
less if you pay off your loan quicker from a refinancing stand point.
You should also ask your broker what the cost would be to refinance at a higher rate.
In this example, you could get a “credit” to your costs if you
refinanced for 4.75% instead of 4.25%, thereby having less money leave
your pocket. The general rule of thumb is that if you
plan to stay in your house for over 5 years, and it costs no more than
20 months until you break even, you should refinance.
30-YEAR FIXED vs. ADJUSTABLE RATE MORTGAGES
The benefit of a 30-year fixed loan is that you know what your
payments are for 30 years. The payment will never change, only the mix
between principal and interest. As a long term fixed loan, you pay up
for the “privilege” of security.
With a 5 year ARM for example, you pay a lower interest amount in
exchange for not knowing what your mortgage rate will be in year 6.
Good thing is that there is generally a 5% cap increase. The bad thing
is, your payments could literally more than double going from a 4.25%
interest rate in this example to 9.25%!
If you took out the 30-year fixed mortgage, in year six you will
still be at 5.25%. Hence, having a strong belief where inflation and
therefore interest rates are going is important.
People think that adjustable rate mortgages are dangerous and bad.
It’s just not true. An ARM is a wonderful option to save you money by
allowing you to pay a lower interest rate if you believe inflation is
benign, and if you only plan to hold the property for a shorter number
of years. ARMs generally come in 1, 3, 5, 7, and 10 year durations.
PITA FACTOR (Pain In The A** Factor)
It would be nice if one could just snap one’s fingers and change the
terms of the loan. Unfortunately, it’s not that simple and you need to
spend at least 5 hours of your time speaking to your mortgage
representative and preparing and signing the paperwork. A good agent
should be able to tell you all the necessary documents you need to get
things going.
The process generally takes about a month given the bank needs to pay
off the loan, send an appraiser to figure out the loan-to-value ratio,
check your income and assets, go through the title company to get the
proper documents, pull insurance records from the homeowner’s
association, and get you to sign everything.
The less you make, and the less busy you are, the more you should
look into refinancing! If on the other hand, you’re happy with your
loan, don’t have a lot of time, and make a ton of money, your time is
worth more than the headache you will go through to save $16,000 bucks
in the example above.
PUTTING IT ALL TOGETHER
If your mortgage rate is currently above 5%, consider calling your
local bank’s mortgage department and asking what their latest rates are
at various durations. The phone call is free, and you will potentially
save thousands over the years.
To recap: 1) ask for rates 1% lower than your
existing mortgage rate, 2) match your fixed rate duration with the
length you plan to pay off the loan and/or own the property, 3)
Calculate the break even duration by adding up the cost of refinancing
divided by the monthly savings, 4) Consider refinances the loan if the
break even duration is below 20 months (lower the better) and you plan
to hold the loan for longer than 5 years.
If anything is unclear, please feel free to ask! I’ve been involved
in a dozen loans with various types of properties, and perhaps I’ll be
involved with one more very soon.
Recommendation: Some of the lowest mortgage rates
I’ve seen are by Quicken Loan. I’ve know at least 20 people in 2012-2013
who have refinanced through Quicken Loan and with some incredible rates
of below 4% for a 30-year fixed and below 2.875% for a 5/1 ARM. I’ve
applied before and got matched 2.625% for my 5/1 jumbo ARM. It’s worth
applying today to
see if they can at least beat your existing mortgage rate since Quicken
Loans is entirely online, and therefore doesn’t have the added
marketing and overhead costs as the brick and mortar banks. Less
overhead costs means more savings to you. There is no obligation and
it’s free.
source: financialsamurai.com
