Mortgage Refinancing

Sam Ngooi Comments

The historically low interest rates of the past year represent an attempt by the US Federal Reserve to stimulate a faltering US economy. The correspondingly low rates determined in the bond market have hurt investors who need income. But these rates have been a boon to borrowers, as the Fed intended. Now is therefore a very good time to consider refinancing loans, especially mortgages, which are usually the largest debt most households carry.

Thirty-year fixed-rate loans are available in the low 3% range, often with few or no closing costs. Rates for 15-year fixed-rate loans are in the low- to mid-2% range. You can contact your current lender and/or a mortgage broker to get specific quotes.

To help you assess whether a refinance makes sense, we present below a list of basic terms; some ideas for how to analyze the refinancing opportunity; and some practical considerations as you go through the process. Please feel free to contact PPA for additional details and help analyzing whether a specific refinance makes sense for you.

Defining Terms

The most basic features of a home mortgage are the rate and term. Rate refers to the annual percentage interest you pay on the total amount of the loan (also known as “principal”). Term specifies how long you have to pay back the principal and interest. Rates can be fixed, i.e. set for the full term of the loan, or variable, in which case the rate can change over time. Fixed rate loans typically have terms of 15, 20, or 30 years. Variable rate loans often have fixed rates for terms of three to seven years, then adjust each year based on market conditions. Rates are typically lower for “conforming” loans, which are below $510,400 for 2020, than for larger dollar amount “non-conforming” loans. For a typical fixed-rate, amortizing (see definition below) mortgage, each monthly payment you make consists of interest and principal, with payments early in the term consisting mostly of interest.

Another key concept is amortization, which refers to the repayment of principal on the mortgage. Amortization schedules show how a specific loan will be repaid over the relevant term. Different types of loans, such as “interest-only”, can lead to situations where a loan is not fully repaid over the term, but typical fixed-rate loans are structured to “fully amortize.”

Basic Refinance Analysis

Deciding whether to refinance usually depends on whether you can find a lower rate for a comparable term, or a shorter term with a comparable rate. The lower rate calculation is typically straightforward; if you can reduce your current rate significantly, and in turn lower your monthly payment, refinancing often makes sense. The shorter-term calculation can be more complicated because it often involves paying more each month than on the current mortgage (based on amortization over the shorter time period). Even so, shorter terms can save significant amounts of total interest over the full term of the loan, especially in today’s low interest rate environment. PPA advisors can help you with these pre-tax calculations, and it also makes sense to contact your tax professional for further advice.

The other key consideration in the current mortgage market is whether to pay closing costs and/or points to further reduce the interest rate. Closing costs include an appraisal of the property value, lender’s fee, and “title and escrow” charges, which allow the lender to secure and fund the loan. Points refer to an additional fee you can pay up-front to lower the rate. Payment of one point (1%, or 100 basis points) on a $500,000 loan, for example, would cost $5,000 (to be paid at closing), and in turn might decrease the rate on a 15-year loan from 2.5% to 2%. Lenders now also allow you to avoid closing costs if you’re willing to pay a higher rate over time (technically you’re still paying the closing costs, but they’re factored into the higher rate). This decision often comes down to whether you plan to remain in your current home long enough for the lower interest rate to offset the up-front closing costs or points. PPA advisors can prepare a basic “break-even” analysis to help make this determination. Consultation with your tax professional is a good idea for this analysis as well.

Practical Considerations

Once you decide to refinance, the lender will underwrite the loan. One of the main factors in underwriting is determining the value of the property, or “collateral”, which is typically done with an appraisal. Once the value has been determined, lenders establish a loan-to-value (LTV) ratio, which sets the maximum loan amount they’re willing to extend. A typical LTV these days is 70%, which means, for example, that you can borrow up to $350,000 on a house appraised for $500,000. (Different types of property, including cooperative apartments, or “co-ops”, and condominiums, often have different maximum LTVs based on the lenders’ assessment of risk in repayment of the loan.)

In addition to the property value, underwriting assesses the creditworthiness of the borrower. This typically involves review of one or more credit reports from the main credit rating agencies, as well as the borrower’s income, expenses, and other assets and liabilities (i.e., debt). Lenders require documents to verify these figures: for income, you’ll need to provide recent tax returns, pay stubs, and K1s (for partnership interests); for expenses, statements for property taxes and homeowner’s insurance; for assets, brokerage statements; and for liabilities, mortgage and, if applicable, other loan statements. These assessments have tightened up significantly since the late 2000s, when inadequately-underwritten loans contributed to the financial crisis of 2008-09. In general, you should expect to provide several documents for the last two calendar years, and several more if, for example, you own other property and/or over 25% of a company.

Depending on how quickly the borrower provides the required documentation, underwriting, loan approval, and closing (i.e., obtaining the funds needed to pay off the current loan and record the various documents in the public record) can take 90 days or more in this period of high refinancing volumes.

In conclusion, mortgage rates are now low enough to justify refinancing in many situations. Please feel free to contact PPA if you’d like some assistance either before, or during, your discussions with a lender or mortgage broker.