Intermediate Information: April 2007 Archives

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

From an email:



I was wondering if you could tell me whether the following ways to save on interest are actually possible. If they are what are the penalties typically associated with these suggestions. I know you have mentioned a pre-payment penalty but what amount is reasonable?



1) Pay a certain amount over your monthly mortgage payment to pay your mortgage off sooner, pay more in principle, and to save on interest. Example: Your minimum monthly payment is $2000 so you pay $2200 a month instead.



2) Pay your mortgage twice a month so that more principle is paid off before interest catches up. Another nice thing about this is that most people are paid twice a month.

**********



Prepayment penalties are something that is associated with the loan your loan officer chooses for you when you sign up. They become set in stone when the documents are signed, the loan is funded and the documents are recorded.



Sad to say, only a very small minority of clients ask about pre-payment penalties at sign up, and judging from my experience with people at a later time, most people either cannot spot it in the documents (there should be a section entitled something like "Pre-Payment" or "Borrower's Right to Pre-Pay". On the other hand, you need to read the whole Note that you're signing enough to understand what every piece says).



As I've said in this article, pre-payment penalties are a function of the market you're shopping in. Not necessarily the best market you can shop in, but most loan officers are going to looking to make money, not necessarily to get you the loan that's really the best possible loan. Pre-payment penalties add to what they get paid, and it's invisible to the client unless you go looking for it. In all markets, there is a trade-off between what you pay in up-front costs to get a given rate on a given type of loan, and what rate you get. Adding a pre-payment penalty (or not removing one) adds to the loan provider's commission, sometimes multiple points, and out of this they give you back a half point or so to make their loan look more competitive. A Good Question to ask and catch many loan officers off-guard is "and what is it without any pre-payment penalty?"



Pre-payment penalties are a thing to avoid if you reasonably can. On the other hand, circumstances can force you to accept one. No loan officer works for free, and if about all you've got is the money for the down payment, accepting a two year pre-payment penalty (meaning it is in effect for two years) can get the loan officer paid while you still get a affordable rate.



Here in California, the maximum pre-payment penalty is six months interest, and that is the industry standard for when there is a pre-payment penalty. A few lenders will pro-rate it, but for the vast majority, they will charge the same penalty on the day before it expires as on day one. This is pure profit, and they're generally not going to turn down pure profit any more than most people will turn down a bonus. So if your interest rate is 6 percent, you're going to pay a 3 percent pre-payment penalty if you sell or refinance before the pre-payment penalty expires. For Negative Amortization loans, the pre-payment penalty is based on the real rate, not one percent, of course.



On some loans, the pre-payment penalty is triggered by paying any extra money. One extra dollar and GOTCHA! But probably eighty percent or so give you the option of paying it down a certain amount extra each year, usually 20 percent, without triggering the pre-payment penalty.



Now as to the alternate payment schemes you mention, the first method, paying extra, is very possible and recommended with most mortgages. Anything extra you pay should be applied directly to principal. Especially in the early years of the mortgage, this has a multiplier effect, as now that you don't owe that money any more, your interest charges in the future will be less so less of your payment goes to interest and more to principal. On a $300,000 30 year mortgage at 6%, your monthly payment is $1798.65. Of this, $1500 is interest - which you're paying just to break even - and 298.56 is principal, which actually goes to pay off your loan. Let's say you pay $200 per month extra. If you're one of those extremely rare people who actually pay off your mortgage, you'll be done in 278 months - 82 months early. Almost 7 years. The interest you pay drops from $347,514 to $256,000 - you saved $91,514 in interest charges by paying $200 per month early.



If, as is far more likely, you refinance after 2 years, instead of owing $292,404, you'll only owe $287,284, a savings of $5120, which means you owe $5120 less on your refinance, and might get better terms because of it. Or you have $5120 more in your pocket if you sell. So it's only a 7.5% rate of return - it is guaranteed. If this mortgage outlasts 95% of all loans and makes it to five years - sixty months - you'll only own $265,114 instead of $279,163, a difference of $14,049. This is money in your pocket or money you don't owe on the refinance, which you're not paying fees on, and which might get you a better deal. Or it's $14,049 more from the sale of your property to buy another one. It's a 17 percent overall return on every penny in you added in five years, including the last payment you made. That's better than you'll do with CDs with the first month's money.



Suppose you only make one extra payment, once. Let's say you make the first payment at the end of the month when you buy or refinance instead keeping the money in your checking account until the end of that month. Making that one payment saves you more than five months at the end of your mortgage if you keep it the full thirty years. Let's say you just pay $200 extra once, that first month that you actually make a payment. You owe $225 less after 24 months, $270 less after 5 years, and $1207 less in the last month of your loan.



Furthermore, the higher your interest rate, the more difference these payments make. Right now rates are still historically quite low.



Your second question, about paying your mortgage twice a month, is trickier, and here's why: What most people who do this are doing is actually making payments every two weeks, not every half month, which means you're making an extra payment per year in pure principal. To separate the two phenomena, let's drag the calculator out. Cut the interest rate in half, cut the payment in half, and double the number of payments. Punch in n=720, i=3%, and let's see what happens. The payment comes out to $898.92. Double this to $1797.85. This is about 81 cents per month difference. If you pay half of the $1798.65 twice per month, you shave less than half a month off of your payment schedule.



On the other hand, make 13 payments in 12 months, and (to make things simple for a simple calculator) that's roughtly equal to making payments of $1948.54 per month, which has you done in the 295th month - almost five and a half years early.



So you see, the twice a month schedule really does comparatively little for you - it's the fact that you are making an extra payment per year that really helps in this case.



So with some banks charging hundreds of dollars to sign you up for things like this (I know of lenders who charge $400 and up just to sign up), I'd suggest instead to instead spend the sign-up money on a direct pay-down of your mortgage (providing you don't have one of those "one extra dollar" prepayment penalties), and keep making those monthly payment with a little extra on the side instead.



This "service" banks provide for their customers is nothing more than a cash-cow fee to pad their own bottom line.



And for the rest of you out there, I say the same thing I said to this person "Please ask if you have further questions you'd like answered"



Caveat Emptor!

I've said upon more than one occasion that the factors at closing are all in the loan provider's favor. Unless they signed up for multiple loans, the typical consumer has no leverage to get the loan provider to play it straight at closing, and actually deliver what they said they would back when you signed the application. Many people never notice that their lender has taken advantage of them until they get the first payment notice, which is far too late to do anything about it. Furthermore, others never notice at all, and of the ones who do notice something is wrong in a timely fashion, eight to nine out of ten are so fed up with the loan process that they sign the documents anyway. I keep hearing sworn oaths from people who signed up with my competitors that they won't sign the documents at closing if they're not what they were promised, yet when I follow up the vast majority of them did. I can only conclude that these people actually enjoy being lead on like the rats by Pied Piper of Hamlin.



Assuming that you are not one of those people who enjoys being treated like a disposable rat by someone who's making a goodly sum of money from your business, what can you do? The first thing is apply for a back up loan. As I say elsewhere, if you've got a back up loan lined up, you've got leverage. Your options are not limited to sign these documents or don't. You can sign the other provider's set of documents, and the person who lied makes zero. Or you can use the existence of an alternative to get both companies, if need be, to give you the loan you were promised in the first place.



But how can you tell if you've been treated right by the loan officer? There are dozens of pieces of paper that get pushed in front of you at signing. Disclosures for this and disclosures for that. Truth in lending statements. Yet more disclosures. Certificates good for a discount here and a discount there. This is partially legal requirement, partially intentional on the part of loan providers. There really is a legal requirement for most of these disclosure documents, but the loan provider likes that they are there because they all distract your attention from where it needs to be focused.



There are three documents at the heart of every loan closing. They are the Trust Deed, Note, and Department of Housing and Urban Development form 1 (HUD 1). I advise reading everything, especially any title transferring documents, so the lender cannot easily throw a curve in amongst the auxiliary documents. But most don't bother trying. The three main documents are where you should be focusing your attention.



Sometimes, the Note is included in the Trust Deed, but most of the time they are stand-alone documents. The Trust Deed gets recorded with the county, while the Note usually does not. Some states that I haven't worked in may use other systems (A Mortgage Note, for instance, which needs an actual court action in order to foreclose, and which California along with most other states have gotten away from because it is more costly).



The Deed of Trust is simple enough. Look over the Deed of Trust enough to see that it properly references and does not contradict the Note.



The Note requires more attention, and cross referencing between it and the HUD-1. Is the amount borrowed consistent with what you were lead to believe? Is the rate correct? Is it fixed for the correct amount of time? Is there a prepayment penalty, and if so, for how long? Check out the repayment terms, and make certain there are the payments are what you were lead to believe. The Note is what you are agreeing to by signing all of this paperwork. Make certain it reads the way it is supposed to. Take your time, read it over, do not allow yourself to be rushed. Do not think to yourself, "I've got three days to call it off" because once you are done signing the odds are long that you will not think about your loan further until your first payment becomes due, and that is too late. Read it now. If there is anything that you do not understand, ask for a clarification. Good clarifications start from a point of the wording that's on the paper, and make easy sense in English. Do not accept a clarification that you do not understand. Do not sign hoping to get a better clarification later. Do not sign period if you aren't certain you understand.



Check out the HUD-1. I'm working on a separate post to cover all of the issues there, but make certain the costs are what you were led to believe, and that it all adds up correctly. The numbers should start with the Old Loan (if Refinance) or purchase price, plus costs, plus reserves if you're doing an impound account, plus prepaid interest, minus any money you're bringing in (down payment, etcetera) or the seller or your broker is crediting you, and that should be the balance of the new loan. Take your time with the HUD-1 and the Note, and do not allow yourself to be rushed. Do not sign until you are certain that you understand and agree. If this takes a little longer than the signing agent planned for, tough. Many loan providers are adept at distracting you with this disclosure or that disclosure. Some companies actually provide them with training in how to distract you, and how to gloss over thousands of dollars that you didn't agree to. Stick to your guns. The Note is what you are agreeing to, the Trust Deed is there to enforce it, and the HUD-1 is the only form accounting for your money that is actually required to be accurate. The Note, Deed of Trust and HUD 1 are what the lender is going to force you to comply with in a court of law. Make certain that they are what you agreed to before you sign them. If they're not, well that's why you applied for a back up loan, right?



Caveat emptor



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