PART TWO—REFINANCING YOUR CURRENT MORTGAGE AND CONCLUDING THOUGHTS
By Kevin M
Yesterday, in Part One of this series, we took a look at the largely hidden costs of purchasing a new home. Today we’ll take a similar look at the hidden costs of refinancing your current home to determine if doing so is truly in your best long term financial interest.
Refinancing is far less expensive than buying a new home, of course, but the decision to refinance your mortgage to a lower rate isn’t always as clear cut as it seems.
With refinances, people tend to be obsessed with rate. But let me offer that rate alone can be a deceptive metric.
CAVEAT: What I’m proposing here is NOT what you will hear from people in the home lending industry. But please keep in mind that the advice I’m offering is based on a long career in that industry.
The Hidden Costs of Refinancing
Yesterday we listed six costs associated with buying a new home, and while not all of them apply to refinancing, at least two of them most certainly do. Each time you refinance you will incur transaction fees (item 3 on the purchase list), and recast the loan term (item 4). But there are considerations for both that are specific to refinances and warrant additional discussion.
Transaction costs. Transaction costs on refinances generally run 1.5-3.0% of the mortgage amount. This will include most of the costs incurred when you purchased your home, including attorney fees, state or local tax stamps, title charges, lender fees, appraisal, termite and flood cert, etc. In mortgage-speak, it is sometimes said that a refinance is “the borrower buying the house back from himself”—which is totally true in when it comes to closing costs.
On a loan amount of $200,000, the closing costs will run at least $3000 (1.5% of the loan amount) each time you refinance. However, complicating this cost is the fact that many homeowners have refinanced several times over the past 10 years. Refinancing a $200,000 loan three times over a decade will cost you $9000! This is yet another hidden cost of refinancing that few factor into the equation because they think of past refinance costs as dead money. But the question needs to be asked: how many times are you going to pay for the same loan?
Resetting your mortgage term to 30 years. We covered this topic pretty thoroughly yesterday, but an additional consideration in the area of refinances is that there is no limit to the number of times you can refinance and thereby reset the loan term. It’s possible that though you purchased your home 15 years ago, with a 30 year loan, that because of repeated refinancing, you still have something close to 30 years left to pay.
In theory, this can be avoided by lowering the loan term on a new mortgage to the remaining term of the existing one. If you’re five years into your 30 year loan, and wish to refinance, the problem is avoided by reducing the new term to 25 years so that you don’t extend the term of the payoff. In practice however, this seldom happens. Next to rate, the most important consideration on a refi is payment, and most people want that to be as low as possible.
A Factor Unique to Refinancing
Yesterday in discussing the root causes of the current housing and foreclosure crisis, we identified perpetual refinancing, or equity stripping, as a major factor:
Perpetual refinancing. Homeowners tapping and re-tapping the equity in their homes through home equity lines of credit and periodic refinances. As soon as equity is built up, it’s taken out for purposes often unrelated to the house itself, so that the house becomes a source of capital for outside financial activity. The darker term for this process is known as “equity stripping”. Because of this, even people who have owned their homes for many years often have little equity.
Part of the problem of perpetual refinancing is that people have come to view mortgage debt as “good debt”. While that may be true in regard to the portion of the loan that was used to make the original purchase of the home, it does not include the portion that may be comprised of previous or planned debt consolidations, or of equity borrowed out for purposes unrelated to the house.
Debt consolidation is not debt payoff—it merely transfers debt from one form to another. Here’s my experience from my many years in the mortgage industry, one that I’m sure could be shared by anyone with at least a few years in the business…
A homeowner calls to do a refinance on his home, looking to take advantage of the low rates to 1) lower the rate on his first mortgage, 2) roll in a home equity line of credit, and 3) payoff a few credit cards and maybe a car loan.
He manages to get the lower rate, consolidate his debt into one payment and in doing so, to improve his cash flow by several hundred dollars per month. So far, so good.
Two years later, the same homeowner calls to refinance again, only this time he has a new home equity line of credit or a few more credit cards he wants to “get rid of”, meaning consolidating them into a new first mortgage.
The only thing “saving” this homeowner is the fact that his house has been steadily rising in value. He doesn’t ever pay anything off, so his long term debt situation continues to deteriorate even though his cash flow improves with each refinance. The payoff of his mortgage has been moved forever into the future as he now owes far more on his home than he did when he bought it.
The basic problem with this pattern is that it relies entirely upon a perpetually rising value on his home. Absent this, the whole scheme collapses, and that’s where many homeowners are today.
I’d like to say that this scenario is an unusual one, but unfortunately it isn’t.
Comparing Apples to Oranges
At the outset I said that refinancing isn’t all about rate, and here is one of the best illustrations of what I mean.
Oftentimes, the obsession with interest rates and payments can obscure more important considerations. Consider the following example:
A homeowner is five years into a $200,000, 30 year fixed rate loan at 6.00%. Monthly payment is $1199.
Rates have dropped, and the homeowner wishes to replace that loan with a new one, same balance, with a 30 year fixed rate loan at 5.00%. He’s paid the loan down a few thousand dollars over five years, but recasts for the original balance to cover closing costs and escrow allowances. Monthly payment is $1074, a savings of $125 per month—looks good.
But this isn’t a straight up comparison; the homeowner will replace a loan with 25 years remaining with a 30 year loan. Were he to recast the new loan on a 25 year term, the new payment would be $1169, a savings of only $30 per month—hardly worth the effort.
If he were to accept the new loan at 30 years, he would save money on his monthly payment, but he would do so largely by transferring those savings to the back end of the loan. He will continue paying his mortgage for a full five years after the original loan would have been paid off.
When taken in this context, the refinance no longer looks so appealing.
Stay in Your House and Payoff the Mortgage
The point of this analysis of the finer points of both purchasing and refinancing is to emphasize that neither activity may be in your best interest if your ultimate goal is a stronger financial position.
Any time you purchase a house or refinance the one you already own you are incurring costs to do so. Much of the seeming advantage of refinancing and trade-up home buying have been an illusion caused by rising prices. In a static or declining price environment, such as exists in much of the country right now, the real costs of churning your mortgage or your housing situation become more obvious.
But what if you abandon refinancing and trading up?
It isn’t very exciting, but it’ll get you to financial independence faster because you won’t be increasing your carrying costs every few years by increasing the loan balance or moving up to a bigger house. You’ll also be avoiding the transaction costs included every time you buy or refinance.
Let your income grow while your house payment stays relatively level, and eventually nearly disappears, and see what affect that has on your finances. Imagine that the house you bought in your 20s is paid off by the time your in your 50s. No prepayments, just making the scheduled payment every month for 30 years. Very simple, very BORING! But very effective.
What’s the secret? Don’t recast the term, increase the balance or trade up to a larger home.
Just keep doing what you’re doing now. Author Robert Ringer referred to such tactics as “the slow, fast way” to success.
There are times when buying a bigger house makes abundant sense, such as when you have children. But this is where some real soul searching needs to be done. Is the real reason you need a bigger house because your family is growing, or perhaps because of some external factor like a housing mania, the new house bug, or even the desire to impress others?
It’s those external factors that are the real force behind high housing costs. So sit back, relax, and without doing anything extra, you’ll reach financial independence a lot quicker.