Prepayment Penalty Now or Wait to Refinance Until It Expires?

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I have an adustable rate mortgage (5.875) which is set to adjust in 8/2008. My prepayment penalty I'm told expires 7/2008. My first goal is to lock in a fixed rate asap. My second goal is to cash out any equity, but not necessary. I've recently been hearing horror stories about people losing their homes over their rate adjustment. Should I refinance now and bite the bullet on the prepayment penalty? or Attempt to refinance quickly as soon as the penalty expires?


later:

my credit score is 712. My current mortgage is 244,000.00 and homes of the same model are selling between 255 - 265,000.00. What more can you tell me?



The answer to this depends partly upon stuff I don't know, and partly upon stuff nobody knows yet.

5.875 is good enough that you probably don't want to give it away before you have to, especially since you're going to pay $5700 to $7200 in penalties. 6.25 is about where A paper 30 year fixed rate loans with no points rates are right now, so over the next year, and it will cost about another $1000 in interest between now and then, as well.

The problem is that nobody knows what rates will be like in July and August of 2008 yet. Nobody knows what your property value might be then either. Nor do I understand your local real estate market well enough to even guess (it's a long way from Southern California!).

It's going to be hard to get enough back in 15 to 16 months to pay for a pre-payment penalty. On the other hand, this could be balanced out if rates end up being much higher then, or if your equity situation is likely to deteriorate.

One thing I can tell you for certain is that there's no easy answer yet. Every answer I give is going to depend upon things nobody knows yet. If it looks like someone with leftist economic policies is going to get elected President, or someone with basically rational economic policy is looking highly probable, that's going to make a major difference in the election year financial markets right there.

Here's what I expect, as far as rates go: They're going up. I expect rates will be at least in the high sixes by then, more likely in the low sevens, at least on thirty year fixed. My guess is that 5/1 ARMs are going to be between 6 and 6.5. Take all of this with a Mega-grain of salt - I fully expected us to be in the sevens by now, and we're not.

But if we postulate a rate of 7% when your pre-payment penalty expires, that will cost you roughly $17,100 per year on $244,000. 6.25% of $250,000 (your loan with your penalty added) is roughly $15,600. You save approximately $1500 per year on your interest by refinancing now, if my guess on interest rates is correct. However, refinancing now will cost you about $7000. $7000 divided by $1500 per year is roughly 4 years 8 months after that to get your money back. I wouldn't do it. That's about six years you've got to keep your loan to break even on the cost of refinancing now, and it's conditional upon things happening that nobody knows.

Now you don't have a whole lot of equity, and if your market falls, you could be upside down, in which case you're going to have to pay your loan down in order to refinance. If there's no way you could come up with that money, that's another reason to consider refinancing now. However, you would be guaranteed to use up pretty much all of your equity by refinancing now.

In your position, I'd just sit tight. Of course that's very hard psychologically, because you are leaving yourself open to the vagaries of the market, which are not under anybody's personal control. Otherwise Bernanke would lower rates every time he wanted to refinance his own personal loans, and that's just not the way it happens, because that's not the way it works. But spending that much money now and over the next fifteen months just in case rates go up and it saves you enough money over the next six years to break even just doesn't make financial sense. Most folks don't keep their loans that long, which means you've wasted whatever portion of the sunk costs you haven't gotten back.

Just one word in closing: There is no reason for a loan officer to stick someone with a credit score over 680 with a prepayment penalty. You can choose to accept one if you want, but my experience says that most folks end up paying them, and the penalty is a lot more than you're likely to save by accepting one.

Caveat Emptor

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This page contains a single entry by Dan Melson published on April 19, 2007 10:00 AM.

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