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Should I refi?

How does refinancing save you money? When is the best time to do so?Homeowners choose different refinances for the following reasons:

  1. Pay less money every month by getting a lower interest rate, thereby reducing the monthly mortgage payment.

  2. Pay more every month, but save money in the long run, by shortening the term of the loan.  For example, refinancing from a 30-year loan to a 15-year loan might result in a higher monthly payment, but the total paid out will be significantly reduced.

  3. Convert an adjustable loan to a fixed loan. When rates are high, adjustable loans can offer lower payments.  When rates drop, refinance with a fixed loan to lock in a low rate.

  4. Consolidate debt. Pay off credit card balances and other debts with money from a refinance.  The benefits of this route are twofold: get a lower interest rate, and become eligible for tax breaks. Debts like car loans, student loans, and credit cards are notorious for their high interest rates, as compared to a refinance.  In most cases, your mortgage payments will be tax-deductible.

  5. If your original loan has a balloon provision, but no conversion option, you are basically forced to refinance.  Be sure your refinance is complete a few months before the balloon is due.

Every homeowner's situation is different, and mortgage plans vary wildly.  You may have heard that you should only refinance when you can save 2% on your mortgage.  This "rule" is an oversimplification, and may or may not apply to your situation.  If your goal is to lower your monthly payments, use this calculation to see if a refinance is worth the cost:

Total cost of the refinance / Amount saved every month = Months to break even

Example: If the fees associated with your refinance come to $2,400, and you will be paying $120 less every month, divide 2,400/120 = 20 months.  If you plan to keep the house for at least 20 months, it makes sense to refinance.
Anyone considering a refinance should consult an experienced mortgage professional.  Shop around for different analyses and offers.  Be sure you understand the options available to you.

Paying points: why or why not?

Should you pay points on your loan?  Use this formula for a rough estimate:

  1. One point equals 1% of the principal. For example, 2 points on a $100,000 loan equal $2,000.
  2. Calculate the monthly savings on the loan as a result of obtaining a lower interest rate. Example: $50 per month
    Cost of the points / Amount saved every month = Months to break even
  3. Divide the cost of the points by the monthly savings to find out how long it will take to break even. In the above example, this number is 40 months. If you plan to keep the house for longer than 40 months, then it makes sense to pay points.
  4. Your mortgage's effect on your taxes can complicate the issue.  Remember, the points are tax-deductible when you are buying a house and not refinancing.  The money you save on taxes helps you break even sooner.

In all likelihood, you should not pay points if you will be keeping the house for less than 3 years.  If you plan to stay in the house for 3-5 years, points will probably not make a difference in the big picture.  If you will be staying for more than 5 years, pay 1 to 2 points.

Do Zero-Point/Zero-Fee Loans Exist?

You notice that rates are dropping, and you start thinking of the money you could save by refinancing.  However, you remember all the processing fees that were added to your last loan transaction and get discouraged.  After all, these things don't come free—or do they?
Zero-point/zero-fee loans are marketed as just that: a refinance with no added fees or surprises.  No appraisal fees, no title fees, and no points to pay.  How is this possible?  Is the loan broker your fairy godmother?

You may have figured it out: loans on the lower end of the market are going for, say, 6.5% with a significant closing cost.  The zero-point/zero-fee loan you've been offered has a rate of 7% with no closing cost.  You'll still pay all those fees, but spread out over the life of the loan, not all at once.  It sure beats your current 8% mortgage!

Technical terms for this situation include rebate pricing, yield-spread pricing, and sometimes service-release premium.  Some mortgage brokers explain it as paying "negative points", so if you understand points you can see how this works.  It's as safe as any other loan and can be a great opportunity to lower your monthly payments.  In fact, some homeowners refinance with zero-point/zero-fee loans every year or two (as long as rates are dropping).

Be careful of one lender trick: they may offer a zero-point/zero-fee loan and pay their closing costs by increasing your loan amount.  This is never a good deal.  If you originally borrowed $100,000, your new loan amount should also be $100,000.  A straightforward lender will always use those "negative points" to pay closing costs, so your rate will be slightly higher than others available.

What is a FICO score?

FICO stands for Fair, Isaac & Co., the firm that developed this method of credit history evaluation.  Since the 1950s, FICO scores have become the most reliable measurement of a borrower's risk level.  In other words, lenders use your score to predict the likelihood of you paying back a future loan.
You have probably heard of the credit bureaus Experian, Trans Union and Equifax.  These entities track your credit history and calculate a score that potential lenders will check when you apply for a loan.  No one knows exactly how the scores are computed, because that is a protected trade secret of Fair, Isaac and the credit bureaus.  What is known is that the calculation models are vast and complex, incorporating data from millions of consumers' credit histories in order to predict each individual's behavior.  Factors affecting the score include:

  • How long you have lived at your present and previous residences
  • Employment history
  • How long ago you established credit
  • Amount of credit used vs. credit available
  • Late payments
  • Bankruptcies, charge-offs, collection activity

Healthy habits, higher score

You can't increase your credit score overnight.  It reflects your true credit history, so the highest scores belong to people who use credit wisely from the beginning.  If your score is lower than you'd like, these behaviors will raise it in the long run.

  • Pay bills on time.  Late payments can bring your score down, and it plummets if creditors must initiate collections against you.
  • Don't apply for credit too frequently.  Whenever you apply, a new inquiry shows up on your credit report, and too many inquiries lower your score.
  • Don't carry a large balance on your credit cards.  Your score is better when you have some unused credit available and aren't "maxed out".
  • If you have limited credit, obtain more.  Not having sufficient credit can impact your score negatively.

If you think there is an error on your credit report, contact the credit bureau that provided the report.  Don't hesitate; if you see activity that you don't recognize, it may be an indication of identity theft.  The three major bureaus all have procedures in place for making corrections.
Equifax (1-800-685-1111)
Trans Union (1-800-916-8800)
Experian (1-888-397-3742)

Why Do Mortgage Rates Change?

You constantly hear that interest rates are going up or coming down.  What drives this change?  You know it has something to do with the overall condition of the economy, and is theoretically controlled by the Federal Reserve.  This question has little to do with the practical process of applying for a loan, but some people want to know more about the economic forces we are at the mercy of.

How does the Federal Reserve get involved?

The Federal Reserve is the government agency that tries to control how much money is in circulation in the U.S. and how high or low interest rates are.  When the economy is "too strong", inflation reduces the value of the dollar and the price of everything goes up.  Here is the chain of events by which the Fed influences your interest rates:

  • The Fed sets its Discount Rate—the interest the Fed charges banks to borrow from its federal funds, which they must do to remain members.
  • Banks, in turn, loan each other money from these federal funds at the Federal Funds Rate, which they negotiate among themselves.
  • Prime Rate is the interest rate banks use for loans to their best customers who have the highest credit scores.  Prime Rate stays approximately 3 percentage points higher than the current Federal Funds Rate.
  • Prime rate is the basis for many other interest rates, including mortgages.  Your credit card may advertise as "prime plus (a set number)".

This is where supply and demand rules come in.  When the economy prospers, more consumers are ready to buy homes, borrow big, and pay higher rates for their financing.  When the economy is down, fewer people demand loans, thus lenders must offer lower rates to move their supply.  However, mortgages are also bought and sold on a secondary market, without consumer involvement.  This market is also driven by supply and demand.

Fannie Mae, the largest purchaser of mortgages in the world, has a huge influence on this secondary market.  Fannie Mae sets size limits on the mortgages it will purchase, thus driving down the value of larger "non-conforming" loans.  What does this mean to you?  If you need a loan that exceeds the Fannie Mae-approved size, the loan will be much harder for a lender to trade on the secondary market.  Therefore, you will have to pay a higher rate.

Watch economic indicators.  When these figures increase, they indicate a strong economy and/or inflation and result in the Fed raising rates.  When they decrease, the economy is weakening and rates usually come down.

Consumer Price Index (CPI)
Durable Goods Orders
Gross National Product (GNP)
Home Sales
Housing Starts
Industrial Production
Personal Income
Personal Spending
Producer Price Index (PPI)
Retail Sales

Unemployment is also a major indicator of the economy's health.  Rising unemployment either accompanies or foreshadows a drop in the CPI, GNP, and other numbers, and rates should drop.

How does a rate lock work?

You've gotten a quote you like from a mortgage lender, and you begin the application process.  Weeks, or even months later, the application process is complete and your loan is finally approved.  However, you're completely caught off-guard when the lender cannot offer you the same rate and terms he quoted earlier.  "Rates went up," he says.  "Take it or leave it."
A rate lock, or lock-in, ensures that the specific loan terms you wanted will still be available when your application finally clears.  Usually, you have already selected a home to buy.  Most lenders want to see your purchase contract for the property before they offer a rate lock, but higher-rate "lock and shop" programs are also available.  Pay attention to the conditions of the rate lock: on exactly which day it expires, and any arcane clauses that render it void.

Lock-ins do cost lenders money, so they pass the cost on to you.  In exchange for locking the rate and points you want for a short period of time, the lender may charge an up-front fee, a percentage of the mortgage, or an extra fraction of a point.  The longer your lock, the larger the charge.  The longest locks (up to 180 days) are for new construction.  Expect to pay a significant fee if you want a lock this long, probably a full point.

Rate locks are supposed to protect you from paying more—but what if rates go down during the lock-in period?  Some lenders allow you to take a lower rate than you locked, charging a "float-down" fee.  You will get a better rate, but not quite the lowest available.  Even without a float-down, if rates have gone down substantially (.375 or more), your lender may agree to a lower rate.  If they don't, you can try another lender.  If you applied through a mortgage broker, this will be easier; if not, you'll be starting the application process all over again and taking the chance that rates don't go back up.

What if my loan is sold? What if my lender goes out of business?

Mortgages are bought and sold all the time among lenders.  Competition in this secondary mortgage market works to bring rates down for consumers.  Whoever buys ownership of your loan must adhere to all your original terms and conditions.  The only thing that changes is the address to which you mail your payment.  You will get notification if this occurs.

If your lender goes out of business, all the loans will be sold to another lender.  Even if you have heard that your lending office is no longer in business, continue making your payments to the same place until your new lender notifies you of a change of address.

Why do I have to pay PMI on my loan? When does it stop?

If you are buying a house with less than 20% down payment, you will probably be required to get private mortgage insurance (PMI).  PMI protects your lender against the costs of the worst-case scenario: foreclosure.  Because specialized companies exist to provide PMI, lenders can accept lower down payments than they used to.  The smaller your down payment, the more your PMI will cost.  Your PMI premium will be added to your monthly mortgage payment.

You are usually eligible to cancel PMI when the loan is paid down to 80% of the original property value, though some agreements require you to pay for a year or two years.  Contact your lender, and if they consider your application you will have to pay for a property value appraisal.  Your lender (along with any investors who have purchased an interest in the mortgage) will make the final decision to terminate PMI.
You can also get out of your PMI if you refinance and get a new loan without PMI.

What's so difficult about comparing Annual Percentage Rates (APR)?

Your "note rate", i.e. 8%, is used to calculate your interest on principal, and by extension, your monthly payments.  The annual percentage rate (APR) is a slightly higher number, intended to reflect more complicated costs associated with the loan above and beyond the note rate.  The Federal Truth in Lending law requires lenders to disclose the APR along with the note rate, to protect the consumer from hidden fees.

In reality, there is no set standard by which APR is calculated.  Every lender includes and excludes different fees and features in their APR calculation.  Some don't even know what their advertised APR includes—a software application calculates it for them!  Obviously, simply comparing APRs when loan shopping won't give you the whole picture.  Mortgage brokers admit that the situation is confusing, but APRs give a better ballpark figure of a loan's true cost than the simple note rate.

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