Published by Joseph and Lihong on July 5th 2016.
While you were enjoying the fireworks this Independence Day I was receiving a crash course in air conditioner maintenance. It turns out that there is a bit more to it then changing out the filter each month. My ignorance must have been obvious to Darrel, my plumber, as he explained; “keep the outside unit free of debris, and if there are leaks then clean out the drain pipe”. Thanks to folks like me, Darrel earns a good living, but hopefully I can avoid needless hits to my wallet going forward.
This experience got me thinking about a common financial mistake … failing to refinance when they can get a lower rate ... for free!
Perhaps there are a few of you out there that know as little about finance as I did about my air conditioner. If so, today is a good day for a crash course in mortgage refinance as interest rates are low.
So when should I refinance?
The key point is that anyone who can refinance into the same product at a much lower rate for free, should do so right away! For example, if you have a 30 year fixed rate mortgage at 4.5% interest, there is no reason not to get the same 30 year mortgage fixed rate mortgage at 4%.
The hard part is determining what rate is “free”. Banks advertise their best rates, but the “points” and closing costs associated with these rates is often difficult to determine. Moreover, these rates always correspond to the best credit scores which are not relevant to most folks. This makes the advertised rates somewhat misleading.
Points are fees paid directly to the lender at closing in exchange for a reduced interest rate. However, by accepting a higher interest rate you can actually get cash back toward closing costs. The trick is determining the mortgage rate that would cost you nothing in closing costs. That means Because the first question you should be asking yourself is can you get the same mortgage with a lower interest rate…for free. So if you have to pay for the new mortgage to get the cheaper rate than it isn’t necessarily a good deal.
You can check rates on many websites, but my favorite is Amerisave.com. The reason I like it is because they give you a range of rates and corresponding “points” so you can easily determine what new rate you can get at no cost. You can also put in your credit score so you don’t have to waste time pursuing a rate that ultimately won’t be offered to you. For example, right now someone in Illinois with a 720-739 FICO score, a $200,000 home value, a 30 year fixed $160,000 mortgage (this corresponds to a 80% loan-to-value), can refinance at a rate of about 5.125% rate for free!
After you hit "search rates" you will find a table of rates by maturity of the mortgage and "Discount Points" / "Lender Credits". Discount Points reduce your rate, but come with an upfront cost. Lender Credits increase your rate, but give you extra cash to pay your "Closing Costs". To solve for your free refinance interest rate, you want to select the mortgage that pays you just enough in Lender Fees to offset your Closing Costs.
If Closing Cost = Lender Credits
Then the Mortgage Rate = Free!
For example, the table below shows interest rates for 30 year fixed rate mortgages with varying "Lender Credits". Notice that “Lender Credits" is $2744 at a rate of 5.625%. Click the "Closing Cost Details" to see if this is enough to offset your closing costs.
At the bottom of the "Closing Costs" page you will see a list of all the closing costs. Note that the "lender Credits" is just enough to cover all these costs plus an extra $83. That's as close as you can get to a free mortgage rate.
Once you know you can save money using Amerisave.com then you should shop around. Don’t bother trying to time interest rate movements. If you can save money for free, lock the rate and refinance. If rates drop further, you can simply refinance again, although there may be a lock out period of 2-6 months. As long as you always refinance at a rate that allows you to cover closing costs with points than you will always win. However, if you can only get a slightly better rate than the process itself (gathering the required documents, reading the fine print on your new mortgage, going to closing, etc…) may be too much to justify the savings.
Maturity and Fixed vs Adjustable
Most folks go with the 30 year fixed even though the average mortgage only lasts 2-4 years. If you have determined that you can get the same mortgage at a cheaper rate for free, you may want to consider the 15 year fixed,10 year adjustable rate mortgage (ARM), and 7 year ARM. The 15 year fixed will typically increase your monthly payment by around 50%, but you can reduce your interest rate by 0.5% to 1% and have your mortgage paid off in half the time.
The 10 and 7 year ARM charges a fixed rate the first 10 to 7 years respectively before moving to an adjustable rate. This makes the product more risky to you because you don't know what the rate will be in 10 to 7 years. However, this only matters if you don't move or refinance in the mean time. Here are three questions you should ask yourself before getting an ARM. If you can honestly answer yes to all three questions then you may consider getting an ARM:
Am I likely to move before the end of the fixed rate period?
Are my expenses likely to go down before the end of the fixed rate period? (ex. kids have moved out).
Am I the kind of person that can handle the stress and financial commitments of a rising mortgage payment?
No matter what product you choose, be sure not to leave money on the table...and keep your air conditioner well maintained.
Happy hunting!
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These are our personal views. This is not investment advice.