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How to Determine if Refinance Makes Sense

Your refinancing questions answered

Oct. 5, 2017

By JACK GUTTENTAG The Mortgage Professor (Tribune News Service)

Question: What is the worst mistake made by borrowers looking to refinance?

Answer: The most common mistake -- it might or might not be the worst -- is assuming that if the monthly payment savings arising from the refinance cover the refinance settlement costs within a short period, such as a year or two, the refinance will benefit them.

What makes this rule of thumb wrong is that it completely ignores the impact of the refinance on how rapidly the borrower will pay down the loan balance.

The proper way to determine whether refinance pays is to compare the total cost of retaining your existing mortgage with that of a new mortgage over a future period that is your best guess as to how long you will have them. In such comparisons, an increase or decrease in the loan balance is counted as a cost or cost reduction.

This is a more demanding calculation than the rule of thumb.

Question: If a borrower is paying a rate well above the existing market, why don't lenders simply drop the rate, avoiding mortgage settlement costs?

Answer: Lenders who service the loans they own sometimes do that, since they would rather cut the rate than lose the loan.

However, most loans are serviced by firms that don't own them. While such firms would like to be able to cut the rate so that they can retain the servicing income, their contracts with the lenders who own the loans bars them from doing it.

Owners fear that if servicers have the discretion, they will agree to rate reductions too readily because they lose nothing from a rate reduction and they retain the same servicing income.

For example, a loan with a rate of 4 percent and a servicing fee of 0.25 percent yields 3.75 percent to the owner. If the rate is cut to 3.5 percent, the net return to the owner falls to 3.25 percent but the servicing fee of 0.25 percent is unchanged.

Question: Can I rent my house immediately after refinancing?

Answer: No and yes.

When you apply for a mortgage loan, whether to refinance or make a purchase, you are asked whether you intend to occupy the collateral property as your residence or if you intend it to be an investment.

If you indicated on your application that you would occupy the house as your residence, which I assume is the case or you would not be asking the question, and if you offer it as a rental the day after closing, you are committing fraud.

You might or might not get away with it, depending on whether you are unlucky enough to have your documents subjected to a post-closing spot check. Assuming you do get away with it, if you get into payment trouble down the road, your fraud may well be uncovered at that point.

On the other hand, if you wait a year before renting the house you will be OK, because everybody has a right to change their mind.

Question: When does a no-cost refinance make sense?

Answer: On a no-cost mortgage, you pay a higher interest rate in exchange for the lender paying your settlement costs.

The question at issue is how long you are going to pay that rate? If you expect to be out of the house within three or four years, it is a good deal. If you stay put for 15 or 20 years, it is a bad deal. Somewhere in between is your break-even period.

Question: How do I determine whether it is cheaper to raise the cash I need by refinancing my current mortgage with cash out, or by taking a second mortgage?

Answer: Compute all costs of both options and determine a break-even interest rate on the second mortgage -- the highest rate you can pay on the second and come out ahead of the refinance option. The second mortgage is the less-costly option if it is available at an interest rate below the break-even rate.

Question: If I feel that I have been bamboozled by the loan officer handling my refinance, do I have any recourse?

Answer: If the property involved is your primary residence, and if the lender involved is not the lender who holds your existing mortgage, you have the right to rescind the transaction and recover any payments you have made.

You must exercise the right within three days of closing by providing written notice of your decision to rescind. To make sure that your rescission letter does not end up in the shredder, send it registered mail with return receipt requested.

About the Writer
Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania.

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Copyright (c) 2017, The Mortgage Professor

Distributed by Tribune News Service.

This story was distributed by TNS - Tribune News Service
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