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.

PART ONE—BUYING A NEW HOME

By Kevin M

In response to the mortgage meltdown/real estate slump of the past two to three years, the U.S. government has intervened with the take over of FNMA and FHLMC to insure the free flow of mortgage money, interest rates are being held down to the 5% level and an $8000 home buyer credit has been put in place to stimulate activity.

But should you as a homeowner take the bait and either trade up to a new and more expensive home, or perhaps refinance into a lower interest rate loan?

I’m going to take the contrarian’s view and argue against either course.

It should be noted that this series will deal specifically with current homeowners. For all of the reasons stated above, now might be an excellent time to buy your first home.

Since this is a long and involved topic, I’m going to cover it in two segments as it pertains to purchasing a new home and refinancing the mortgage on your current home. Today, we’ll take a look at purchasing, and cover refinancing tomorrow.

A Different Time—and Maybe Even a Different Country!

There was a time, yes, even here in America, when a primary goal of homeowners was the payoff of the mortgage on the family homestead. Many of the current generation of retirees are benefiting from the payoff of their mortgages earlier in life, conditioned as they were to payoff debt as soon as they were able.

Have you ever heard of a “mortgage burning party”? Chances are you haven’t, at least not in a couple of decades, because with our current world of trade-up-or-refinance-every-few-years routine, most mortgage indebtedness just gets recast and expanded again and again, with the end never in sight. A mortgage has come to be viewed as permanent debt.

If you’re truly interested in improving your long-term financial situation, or of ever retiring in some degree of comfort, the payoff of your mortgage should be a practical reality, and not just an oft-stated goal that gets pushed off into the indefinite future. The most fundamental aspect of the mortgage foreclosure crisis is people being too deep in debt!

The Root of the Current Crisis

In the struggle to revive the housing market, it’s worth revisiting the issues that are at the root of the current crisis:

Overbuying. The mantra in the real estate industry is to buy the most house you can afford, and even more if you can. This has been accomplished by the reduction or outright elimination of down payment requirements, the relaxation of income guidelines, the introduction of low teaser rate loans (interest only and adjustable rates) and no income verification programs.

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 so-called ATM effect. 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.

Overvaluing of property. People like higher values, especially when it concerns what is for most, the largest asset they own. The situation becomes even more pronounced when the housing market is booming, and prices can eventually catch up with expected values. But appraising a property is not an exact science, and the best that can reasonably be produced is a value range. A house might be valued at somewhere between $180,000 and $200,000, with a reasonable placement at the midpoint of $190,000. But in order to make the customer, agent, builder and lender happy, the value will be set at the upper range of $200,000. Or maybe 205. Or even—210—maybe? A house will be sold at that value, or a refinance may be taken based on it, but what that means is that the loan will be based on an optimistic valuation, that is value which may not exist. Unfortunately, in a soft or declining market, the exact opposite comes into play, and now houses are being valued at the lower end of the range. People are now awakening to the fact that they have no equity, or perhaps they are even in a negative equity position. The sudden realization of a negative equity position is a major driver in people walking away from their homes.

To be fair, there are other factors as well, including overbuilding and the declining economy. However both are beyond our ability to control, and it was largely the effects of the three causes outlined above that produced the oversupply of new housing as well as the bad economy.

Is Now a Good Time to Buy a New House?

Rates are low, it’s a buyers market and the people who should know are saying the “bottom is in” and now is the time to make a move; are they right?

Maybe this is good news for the national economy, and certainly for the beleaguered housing industry, but what does it mean for you personally?

In addition to getting a new house, usually a bigger one, here’s what else you’re taking on:

1. A bigger mortgage. Since you’re mainly trading equity from your current home to a new one, the difference in price will mostly be paid for out of the proceeds of a larger mortgage.
2. A higher payment. A bigger mortgage equals a higher monthly payment. A higher property value generally translates into higher real estate taxes and homeowners insurance.
3. Transaction costs. Most people ignore these because either they’re being paid by the seller, builder or lender. Newsflash: no matter how the deck is shuffled, you’re paying the transaction costs! Even if you don’t pay direct at the closing table, you will pay through a higher sale price, or a higher interest rate (if the costs are lender paid).
4. Your mortgage term resets to 30 years. If the remaining term on your current mortgage has 22 years left on it, you will most likely start from square one with a brand new 30 year loan in an effort to keep the new payment at a minimum. If it was ever your intention to payoff your mortgage, you just took an eight year step back. Even if the payment on the new house seems manageable, multiply the monthly payment on a new home X 12 months X the extra eight years you’re taking on with the new loan, and you’ll get an idea as to the back end impact of the transaction on your finances. How might that money impact your retirement?
5. Moving and resettlement costs. Usually ignored in tallying the cost of moving, but these charges are very real. And it isn’t just the cost of hiring movers. There’s also the cost of moving supplies, utility deposits, restaurant food eaten on the fly, and maybe a night (or two, or three) in a hotel.
6. Property customization. You just moved into your new home; is all as you want it to be? Never. There will always be a need for customizations. New carpet, new curtains, the replacement of a piece of furniture that just doesn’t work in the new house, and those pesky repairs that the seller/builder didn’t complete (or reveal) before closing. Even with new construction, there’s no free ride here.

The basic problem with buying a new house every few years is that you never stay in one house long enough to get the mortgage under control. You stay long enough to build up some equity, then sell and move on to a newer, and typically more expensive home, where the whole process begins again—from square one.

But there is one more problem peculiar to this market from the standpoint of an existing homeowener: the same factors that are causing favorable property values on the buy side will work against you in the sale of your own home. You’ll pay less for a new home than you would have two or three years ago, but in all likelihood, you’ll get commeasurably less for yours.

Tomorrow: PART TWO—REFINANCING YOUR CURRENT MORTGAGE AND CONCLUDING THOUGHTS