Jack M. Guttentag
Jack M. Guttentag, known as the Mortgage Professor. He is professor emeritus of finance at Wharton School of University of Pennsylvania, Philadelphia. MtgProfessor.com
With mortgage interest rates at historic lows, many consumers have been refinancing…thinking about refinancing…or even considering buying new homes.
But upheaval in the economy and financial markets, along with changes in many of the rules and requirements regarding mortgages, have turned conventional wisdom on its head and altered how various mortgage options might fit into someone’s financial planning. Many people simply want to slash their monthly loan payments, while others see today’s low interest rates as a chance to pay off a home loan quicker by getting a new, low-interest loan with a shorter term.
The best option may depend on how long you plan to stay in your home and what other debt you have. And new regulations can make it much harder for some to obtain an attractive mortgage.
What you need to know to get the best mortgage for your needs…
The biggest changes have to do with stricter borrowing rules. Unless your FICO credit score is 740 or higher, you no longer can expect to get the best available interest rate, regardless of your net worth or income or how much your home is worth. Likewise, forget about “stated-income” mortgages, nicknamed “liar loans” during their heyday, that let people apply for mortgages without income documentation.
A mortgage broker or loan officer can help you navigate the sea of products and lenders. Be aware, though, that the government’s financial-regulation overhaul has changed the way that these loan originators are compensated. The changes are meant to discourage them from steering borrowers into loans that are not necessarily the best for the borrowers but that give the originators the largest commissions. As a result, you may have to pay a broker a flat fee of $200 to $400 up front. Brokers now are required to disclose any payments that they receive from the lender. However, loan officers, who are employees of the lender, are not required to disclose their compensation.
Before you decide what kind of financing is best for you, review the available options…
Shorten your loan term. In mid-August, the average rate on 15-year conforming (nonjumbo) mortgages was 3.9%, vs. 4.4% for 30-year loans. Those low rates, on top of the shorter repayment period, mean that you would pay far less interest over the life of the loan by refinancing from a 30-year to a 15-year mortgage. Example: A home owner who took out a 30-year mortgage of $200,000 at 6% in 2005 has a remaining balance of $186,109. If he/she now refinances the full balance into a 15-year mortgage at 4%, the loan will be paid off 10 years earlier and the total future interest payments will decline to $61,683 from $173,624.
To calculate the actual savings, factor in closing costs, usually 1% to 2% of the loan amount but potentially as much as 4%. (Your current lender may waive closing costs if you refinance with that lender.) Also, you may pay more in taxes every year as a result of a lower interest deduction. And of course, monthly payments are higher with the 15-year loan. In the example above, the home owner’s monthly payments would rise from $1,199 to $1,377.
Do this if: You can afford higher monthly payments without hardship and want to pay off your mortgage faster—say, in time for retirement.
Avoid it if: You have high-interest-rate debt, such as credit card balances or outstanding tax bills, that you could pay off instead.
Reverse strategy: If you’re strapped for cash, currently have a 15-year mortgage and will be in your home long enough to recoup closing costs, consider refinancing into a longer-term loan.
What about 10- and 20-year loans? These products can be useful if you want to time your payoff very precisely. But 10-year fixed-rate mortgages are priced only slightly below 15-year loans, and rates on 20-year mortgages actually are closer to 30-year rates than 15-year rates. Unless the payments are beyond your budget, the 15-year product is the most cost-effective bet.
Caution: Some ARMs come with prepayment penalties. Make sure you understand how much you will get charged for paying off an ARM early. The “good faith estimate” you now receive within three days of submitting your loan application shows any prepayment penalty.
Do this if: You want to reduce your monthly payments, and you’re quite sure that you’ll leave your current home before your rate adjusts—but not too long before your rate adjusts, so you avoid prepayment penalties.
Avoid it if: There’s a good chance you’ll move either well before or well after the first rate adjustment.
The higher pricing means that unless you sell or refinance when the IO period expires, you’ll face a very substantial increase in monthly payments—and you will pay more over the life of the loan. The more you can sock into principal before the IO option ends, the better.
Do this if: Your income is rising, and you have the discipline to make principal payments whenever you can.
Avoid it if: You’re using the strategy to buy more house than you can afford.
No more. Today, many lenders flatly refuse to let you borrow more than 80% of what your home is worth. As a result, it may make sense to bring more cash to the deal, taking out a mortgage that’s smaller than your old one. By keeping your loan-to-value (LTV) ratio at 80% or lower, you qualify for the best available interest rates. In fact, this strategy may allow you to refinance into a 15-year loan, saving even more in interest.
Plowing cash into a mortgage is among the most profitable things you can do with cash in today’s economy, where savings earn tiny yields. By comparison, with a “cash-in” mortgage, you can earn up to double-digit returns.
Example: You’re five years into a 30-year fixed-rate mortgage at 6% interest, with a loan balance of $270,000, and your home is worth $320,000. You’re not underwater, but you don’t make the 80% LTV cut. A cash infusion of $14,000 would make up the difference. If you refinance into a new 30-year loan at 5.5% and pay 1% in closing costs, the annual pretax return on your $14,000 investment will be 11.3%. At a new interest rate of 5% with no closing costs, your pretax return would be 27%.
Do this if: Your home has declined in value since you got your previous mortgage but you want to take advantage of lower interest rates. It also is a good strategy if you have a jumbo mortgage (higher than $417,000 in most areas) that you want to shrink down to qualify for a lower interest rate.
Avoid it if: You have more costly debt that you could pay off instead.