Mortgage Monday

An old client called me last week to enquire about refinancing his mortgage while the rates were still low. He has a fixed rate first mortgage and a large HELOC, and wanted me to run numbers for different scenarios to see what the best plan of attack would be. I thought it was a great exercise for anyone to do in the first stages of refinancing a mortgage simply to see if it was even worth doing out of the gate. As a great example, I will review out conversations and questions using my client’s numbers.

Jack’s current housing situation:

Current home value 550,000

Purchased 7 years ago

First mortgage:

·         195,000 balance

·         7 years into a 30 year fixed

·         6.75%

·         Monthly payment $1,297

 

HELOC:

·         200,000 balance (full equity line in use)

·         3 years into a 30 year loan @ 3.5% (variable)

·         Current payment (interest only) $583

Forget about his taxes and insurance for now, because those amounts are constant. What we want to do is compare only mortgage principal and interest payments.

Jack wanted to know if he should just refi the first mortgage or combine the first and second mortgage and get one 30 year fixed loan while the rates are still low? That depends on a few things so I answered his question with a battery of questions. Don’t you hate that?

Is your reason for the refinance to lower your monthly nut or to take advantage of the lower rates being offered? If you want to lower your monthly payment, then you want to go with the longest term, even if it kills you to go back to the starting line. A 30 year fixed rate payment will always be lower than a 20 year fixed rate mortgage even though the later will have a lower interest rate (typically a 20 year fixed rate is ¼% lower than a 30 year) – we have a cool example further down.

How long will you be keeping the house? If you are not keeping the house for more than four or five years, it might not pay to refinance your mortgage. It can take up to five years to recoup the closing costs laid out to do a refinance (depending on the state you live in). If you know for sure you are getting relocated in two years, then don’t do it. However, if you simply think you will be out of the home or want to move in three years, remember life gets in the way of your plans.

Do you typically pay only the interest on the second mortgage or do you often pay down principal?  If you can only manage the minimum payment on your second or don’t have the self control to pay more, then you will probably never whittle away at the principal. If you won’t pay, can’t pay or don’t count on winning the lottery, maybe you should consolidate just so you are forced to pay down the loan.

Do you still need to have a HELOC open to use as an emergency fund? Even if you consolidate your mortgages, you can still leave the HELOC open for use later on in life. However, the first mortgage will be considered a “cash out” refinance and the HELOC will need to be subordinated. There are tons of restrictions for cash out amounts and combined loan to values for each lender. So it is important to review the numbers to see if you can even go the way you were thinking.

Would you like to keep the monthly payments the same and refinance the mortgage into a lower term? Here’s another thought. You are fine with your monthly payments, so it is okay if they stay the same. If you can handle the monthly payment and get a lower interest rate, play with the number of years (term) until you get the same payment or even a little over. In other words if you have a $200,000 loan at 6.75% for 30 years, your payment will be $1,297 a month. If the loan (200k) is refinanced to a 4.25% 30 year fixed, the monthly payments will be $983 with a savings of $314/month. If we lower the term to 25 years (4.25%) the monthly payment is $1,084. If we look at the 20 year loan (4% rate) your monthly payment will be $1,211. The verdict: take the 20 year loan if you can handle the same payment, the 25 year loan if you want to save a little, but don’t want to go back to square one and the 30 year, if you really need to lower your cash flow!

What to do- what to do????

Refi the first and keep the second:

New first mortgage of 200,000 (4.25%) 30 year fixed and HELOC still at 3.5% but will go up with Prime Rate

983 plus 583 = 1,566

Refi both loans

400,000 @ 4.25% 30 year fixed

1,967 but it pays off the principal on both loans-

 

In the second example, Jack has one loan and will make principal and interest payment on a very low rate for 30 years. In the first example, Jack is saving over 300 a month on the first, but still paying the minimum on the second.

Of course, Jack needs to qualify for a mortgage and the house must appraise at a value that will cover the combined loan to value, but let’s assume that all works out. Jack needs to decide if he wants to reduce his monthly, payment, reduce the time to pay off the loan or simply pay off the first mortgage and keep the second mortgage open.

There is a lot to think about, but it is important to do the “what if” conversation early in the game and have different scenarios available in case the game changes later on. Lately there have been monkey wrenches such as low appraisals, lenders that will not subordinate and high qualifying ratios for second mortgages. It is not easy to qualify for mortgages and expensive, so the wise man says, do your [own] research upfront to avoid wasting time and money.