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Beware No Cost Refinancing Offers

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According to CNN, in October the bulk of the ARMs that were signed in the last 3-5 years will start adjusting to the tune of $10B in mortgages. Ten freaking billion dollars of mortgage debt. That’s some heavy stuff there. Now, some of those mortgages will go into foreclosure, much to the delight of real estate investors looking to snatch up some deals, and some will be refinanced. It’s that second group that is the target of the latest round of mortgage company advertisements so you have them to thank if you start getting sick of hearing them on the radio.

One of those offers is probably going to be a no closing cost refinancing offer, which sounds great, so what’s the catch? There are two potential catches and in both cases it makes a potential great deal (no fees? lower rate? win win right?) potentially crappy.

Case 1: Closing Costs Are Rolled Into The New Loan
Let’s say they roll in $3,000 into your new loan, does it really hurt that much? Well, over the course of 30 years that $3,000 at a rate of 6% tacked onto a $300,000 loan will cost you an extra $3,473.18 in interest. That’s right, you will pay $3,473.18 in interest over the course of thirty years in addition to the $3,000 tacked on extra as fees. So the mortgage company makes their fees twice over, bad news for you.

Case 2: Term Is Reset To 30 Years
This isn’t really an independent case because this will always happen in a refinance. You basically reset the clock and start paying more towards interest all over again but this could be how the company makes its money if it truly is without any fees (as in they don’t roll it into the balance). Is this bad for you? Maybe, maybe not. What you’ll need to do is figure out how much you’d pay towards interest for the balance of your current mortgage and compare it to how much you’d pay in the new loan, that’ll help you decide whether it’s worth it for you to refinance.

For example, on a 30 year fixed loan for $200,000 at 6.5%, you’ll pay over $255,000 in interest over the thirty years (use Dinkytown’s calculator). If you refinance your current mortgage to the one I just listed, it will cost you over two hundred and fifty thousand dollars. How do you determine how much interest you have left to pay on your current mortgage? That’s a little trickier because of the front-loaded interest amortization but you can take shortcuts.

The easiest shortcut is to just to put in your current loan and click on the View Report. You’ll want to enter in the data as if it were a new loan, so if you started at $200,000 then you’ll want to put $200,000 into the calculator, not your current loan amount. Now import it into a tool like Excel and start adding up the interest payments starting from your next payment onto the end of the loan to figure out your total interest.

To import the data, I would copy and paste the amortization schedule into a text file, then try to open it in Excel. Excel will ask you how you want to parse the data, you want to select “delimited” on the first page and then “tab” on the second page, that will give it to you in a format you can use.

Calculating Whether The Refinance Is Worth It
Let’s say you’re four years into (48 payments) a 30 year loan for $200k with an interest rate of 7% and you have an offer of a 30 year loan for your balance, which happens to be $190,732.63 (that’s right, you’ve only paid off $10k in principal in four years), at 5%. Should you take it?

In this case, yes. Your monthly payment will drop from $1330,60 to $1023.90, but your total interest paid will go up. If you continue your current loan, you’ll have to pay an additional $224,203.78 in interest, if you choose the new loan you’ll only have an additional $177,867.61 to pay. If the new loan interest rate was only 6.5%, this would not be worth it because over the coarse of that loan you’ll pay over $243k in interest – making it a bad deal. 6.08% incidentally is the breakeven point for this particular scenario, so any loan of less than 6.08% is a good deal given zero closing costs (this holds up the rule of thumb that you should only refinance if your new rate is better by at least a percent).

{ 3 comments, please add your thoughts now! }

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3 Responses to “Beware No Cost Refinancing Offers”

  1. Kent says:

    Great post! I imagine this is a topic for another post, but the original purpose for the loan/re-fi and the “return” on the “investment” should dictate the overall value of the financing. For example, if the new loan improves cash flow by $300 per month and that money is enough to start a new business that will bring a “return” on your “investment” greater than the 7.0% you are paying on the loan, then a re-fi can be wise. It’s called leverage…

    • jim says:

      Very true but that’s outside the scope of the article, I was just talking from a strict total cost perspective. Excellent point regardless.

  2. Ted Valentine says:

    1. You don’t have to reset the loan to 30 years. You can set it at 25, 20 years, whatever. Most people do this because it gives them more cash month to month. Most people also take cash out.

    2. If you want to pay the house off as cheaply as possible, the best thing to do is to refinance at a better fixed rate, pay the closing costs, and move down in term, say from a 30 to 15 year mortgage. If your income has increased since you bought the home, doing this will not likely increase your income to mortgage payment ratio.

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