With the historically and incredibly low mortgage rates over the last 6 months or so, I have received lots of uninvited overtures to refinance. Today's departure from my usual car stuff will touch on some mortgage-related stuff. I am not a banking professional; I have just bought/sold and re-financed a few houses over the years, so I've learned some things.
I am posting this because I just walked away from a re-finance after the lender hid the fact that to reach the advertised interest rate there were 3% in points, making the loan a bad deal. By bad deal, I mean it would have taken over half the life of the loan to pay for the fees. To be fair, this was in part because the rate wasn't that much better than what I have now, after all was said and done. I figure there are folks who do not have as much exposure to lending trickery so this might help you avoid them.
Some Terms
ReFi - a simple abbreviation of re-finance.
P&I - Principal and Interest. This is the only part of your payment that the refi folks will talk about. Depending on your situation, this could represent as little as 60% or so of your monthly payment
PMI - Primary Mortgage Insurance. This is total bullshit, but if you were granted a loan with less than 20% down, you probably have this added to your monthly payment. Basically, this is an extra fee to underwrite the additional risk that the bank is taking because the principal outstanding on the loan is more than 80% of value of the property. They do this to get you into a competitive interest rate without taking on extra risk that would be reflected in a higher rate. Getting PMI removed from your loan can be very difficult, and sometimes a refinance is the easier way to do it.
Points - a percentage of the principal balance charged at the origination of the loan so you can get the interest rate. I think of this as an interest balloon payment at the start of the loan.
Escrow - an account (that usually generates 0 interest for you) that holds a portion of your monthly payment for paying your homeowners insurance and land taxes. Depending on where your property is, this could be a significant percentage of your monthly payment.
Coupon - this is the little paper ticket that you include in the envelope when you send a paper check. With online banking, many more folks pay online or use auto-pay, but the coupon explicitly states what each portion of your payment is for.
Term Loan - the agreement you sign is for a fixed period of time (15, 20 or 30 years, usually).
Payment Schedule - Payments are calculated based on your term using an annuity/amortization schedule. This makes all but your last payment consistent for P&I. The escrow portion is re-evaluated periodically.
Pre-Paid's - there is a short list of things that need to be pre-paid for the remainder of the partial month in which the loan starts. This includes a partial month of interest, and home owner insurance.
Initial Escrow - usually you need to juice the escrow account to get things started. Similar to pre-paids, this is determined based on the annual review schedule of your escrow amount, so this could be a pretty big number, depending on where you are on that calendar. Included are homeowner insurance and land taxes. PMI may need to be prepaid this way. You can wrap this into your loan, but it is best if you can avoid that.
Closing Costs - the wrap-up of all the inception fees incurred in the creation of the loan. You would think that the interest pays for that, but nope, you get to pay for those costs up front. Makes you wonder what the interest rate is for once you see all the fees
Inception Fees - processing fee, underwriting fee, recording fee, title endorsement fee, title lender policy fee, title settlement fee, etc. This list seems bigger, and their names are more obscure, every time I do a loan. One day you'll have a "speak to a human" fee; just watch.
Earnest Money - some money you put in with the offer to help secure the purchase. This doesn't apply in a refi, but this is money you may lose if you walk away from the deal. Losing it or not depends on how the offer was structured. You can walk away right up to signing, though the longer you go into the process, the less supportive your loan officer, agent, etc will be.
Loan-to-Value (LtV) - the ratio (usually represented as a percentage) of your home value that is financed by your loan balance. This is important for PMI calculations, but also influences your credit rating. So, while it is important for this mortgage conversation, your variable rate credit lines could see a sympathetic increase in the few months after you close the loan. They really do get you coming and going, don't they?
Scared yet? I hope not. The terms sound scary, but ultimately, you agree to an interest rate, term and amount down. You can abort your loan at any point up to the final signing day, though you may lose some earnest money if you do.
APR versus Interest Rate
The interest rate is the rate you are actually being charged as a part of the term loan. This is the rate used to calculate the annuity for the P&I portion of your monthly payment. The APR is a representation of how expensive the loan is as expressed in an interest rate form. It pulls in all the fees, points paid, etc. and considers what the interest rate is if all of those were considered part of the interest rate instead of something you pay up front. Most folks glass-eye when they see the APR, but it could be very telling. For example, your advertised interest rate could be 2.75% which sounds pretty good. The APR, however, could be something like 3.5% which, over the course of 30 years, is a big difference. The bigger the difference, the more you are paying upfront. So, while this number is not part of your payment calculation, it may prod you into looking at the fees, prepaids and points to see if things are what you expected.
Some Pits-
Buying to Your Limit
Real estate agents are great. They help you find a home, navigate a big portion of the lending process and help you understand the market so you are making a more informed decision. For these things, their commission is understandable. For a very short and intense period, they are like a best friend. The one thing that many agents will do is push you into a more expensive house than you may have intended to buy. That is not very best-friend-like. I won't say it is because of their commission, but their commission is percentage-of-home value based, so you decide why. Some are oily, some are warm, some share their limits, others don't; do your research. Like a lawyer, this is one of the most important persons for you to have picked well.
Say you are qualified to borrow $200kUS. Good for you, that will get you something nice in most US markets. That doesn't mean you need to buy a $200kUS house, either. I suggest that when you talk to your agent, at the very beginning, don't talk about what you are qualified for. Talk about what you are willing to spend, which, hopefully, is a lower number than what you are qualified for. Eventually they will learn what you are qualified for, and that is when your spending decision is subject to influence. Be steadfast! You could find yourself buying a $230kUS house because you qualified for $200k but have $30k in hand. You picked your team (lender, agent), are they following your lead, or their own?
Points
Recently, I walked away from a re-fi because of a charge for points that the lender did not disclose up-front. The re-fi was pitched based on the existing principal, demonstrating a significant monthly savings. What he did not disclose was that arriving at that monthly savings was through financing over 3% of the original principal again through "points". That 3% principal increase then spread out across the term consumed all but $50/month of the monthly savings originally advertised while increasing my overall debt load. So, a 3% increase in principal for $50. Playing this out in real numbers, if your principal was $200kUS, 3% points would make the loan balance now $206kUS. That $6kUS increase is offset by the $50 a month savings, but even at 0% interest, it would take over 120 months (or 10 years) to pay for those points plus a couple months for the interest accrued over the period. So, it would take over 10 years before you were really enjoying the new rate, assuming you held the property that long.
In today's low interest market, you should be able to avoid points, but be aware there are lenders who will hide this fact in hopes that you will feel like you are so invested in the deal that you'll just go along if you find out. Shark alert! At this point in my process, my sole regret is the lost time. Rates are rising again, and I think I missed my window to get under my current rate. 1st world problem, I know.
PMI
I railed about this a little bit above, but this is another one of those things loan officers avoid talking about. Consider that if you are unable to get your loan-to-value (LtV) below 80%, you will be paying an extra fee every month. So, if you fall in love with a house that is at the limit of your borrowing capacity ($200kUS in my example above), but you only have 15% ($30kUS, which is still a lot of money) to put down, you will be penalized for that. Since LtV is above 80% (it's 85%), you get to pay an extra fee that could be as high as 2.25%. For our example, let's say its in the middle of the Freddie Mac published range, and call it $100US. An extra $100 may not be enough to make you want out of the deal, but better to know it's coming. You may need to ask if you are going to have to pay one, because, like I said, this bad news is not consistently volunteered.
Some Math
To compare a good loan deal against a bad one, start with the fees and the rate. Avoid points and do the math if it will be part of the deal. If you are refinancing, it is easy to become complacent and not do your due-diligence. It's your loan, and your monthly spend. Only you can decide when to change it with a refinance, and only you can decide if a fee or points are worth what you are getting. For a new mortgage, consider how much you have to put down as much as you consider how much you want to spend. Your lending limit is only interesting if it is below what you wanted to spend. If thinking in terms of tens-or hundreds- of thousands of dollars is hard to wrap your brain around, you can back into a spending limit based on what you are willing to spend per month via an online mortgage calculator.
Consider our ongoing example, where we have $30k to put down, want to cap our investment at $170k (or maybe a monthly spend at $1k), and we got pre-approved for up to $200kUS. If the market, your real estate agent or your own wandering eyes land you at a $200kUS property, what is the monthly cost? I got these calculations from here, assuming a 3% interest rate.
$1084/mo: $717(P&I) + $104(Homeowner Ins) + $175(taxes) + $88(PMI) on a $170k (200k-30k down) loan
If you stuck to your plan, what's the monthly cost on that $170kUS house?
$916/mo: $590(P&I) + $104(Homeowner Ins) + $149(taxes) on a $140k loan (170k - 30k down)
You save $168/mo and avoid PMI. And you're under $1kUS/mo.
If you got swindled into paying points and stretched into that $200kUS house?
$1113/mo: $742(P&I) + $104(Homeowner Ins) + $175(taxes) + $92(PMI) on at 176k loan (200k + 6k points - 30k down)
Those points cost you another $29 per month in P&I plus another $4/month in PMI (because the principal bumped up).
If you avoided the points, but expanded to the maximum loan ($200kUS) for a $230kUS house?
$1253/mo: $843(P&I) + $104(Homeowner Ins) + $201(taxes) + $104(PMI) on at 200k loan (230k - 30k down)
But if you avoid the points, and stick to your plan, you earn/save $197/mo in P&I plus the $92 in PMI for a total of $289/mo. If you arrived at $170k from a target of spending no more than $1k/mo, you hit your goal, and have $84/mo available for improvements or paying down the principal. Here in Oregon, land taxes go up every year, so you will eventually, in future years, need that wiggle room to go into that monthly payment. Sorry.
On the other end, if you went to your absolute lending limit, you are spending an extra $337/mo for that extra $60k of purchase price. That includes PMI, and a higher tax bill. Depending on your plan going in, this could create a house-poor situation that adds stress to your life, your relationships, etc., so step wisely.
There Are ALWAYS Options
These differences help to highlight how easy it is to be house-poor when you buy a house. Finding a house that is within your spending limit may push you out of your most-desired neighborhood. You can (a) pay to get in now, (b) save to get in later, or (c) buy-in where you can afford, and have market-lift you into your target in a few years. Option b only works if you can save faster than the neighborhood is appreciating; this can be emotionally exhausting as well as very difficult depending on your target. This is a mid-term strategy (think months not years). Option c reduces how much you need to save ongoing since the sale of the where-you-can-afford house will produce funds for the next down payment. This is a longer term (think years not months) strategy. Option a is absolutely a short-term strategy, and brings with it the cost of getting what you want now.
I think the most important advice I have is for you to do your own research and decide for yourself what you are and are not willing to do. Buying a house is unlike buying a TV where we will sometimes overbuy in a knee-jerk way. You do not want to be making knee-jerk or uninformed choices with a 30-year mortgage. The clarity from an entry plan will be very useful when others try to move you in a direction that might benefit you, but will definitely benefit them.
That's it for today. Next time, I will be back under or inside the bus doing something car-related.
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