Why you should look at refinancing now (Part II)

In the second half of this series, we’ll examine what to consider after you’ve narrowed your search to a handful of lenders and received quotes from each. You can read part I here if haven’t already done so.

After looking through each estimate, it’s tempting to simply go with the lowest rate and lowest monthly payment, but those numbers don’t tell the whole story. There are other elements to be mindful of, which include understanding the difference between the interest rate and the annual percentage rate, typical closing costs and which are negotiable, and understanding a new cost that took effect December 2020: the adverse market fee.

The difference between the interest rate and the annual percentage rate (APR)

You’ll likely find that there are two numbers listed in the estimates you’ve received. The annual percentage rate (APR) is likely higher than the interest rate and in some cases, can be substantially higher. The difference between these two numbers is that the APR includes the all-in costs associated with the refinance, such as the upfront closing costs and any points (upfront interest) you may pay to acquire that rate. Compare that to the stated interest rate on the loan, which is what your monthly payments are calculated on. In short, the APR is an easy way to compare quotes.

That’s why you may find a fantastic rate that stands head-and-shoulders above the competition, but it could come at an extraordinarily high cost, which will be reflected in the APR. On the flip side, you could also find an APR that is lower than the stated interest rate. In this situation, typically in competitive markets, you can find rates where the lender is offering you a credit to entice your business with seemingly no strings attached. 

That may leave you asking, this sounds too good to be true and there has to be a catch. How does the lender get paid? To answer that, make sure you receive a full quote, since preliminary searches stating a lender credit more than likely may not reflect all the closing costs (but will be in the APR). And if there truly are no upfront costs with a lower APR than the stated interest rate, the lender is likely going to sell your mortgage immediately after they originate the loan. In other words, they are paid on the back-end, whether it be by Fannie or Freddie or by institutional investors who are looking to purchase these types of loans, package them and sell them off to others who are looking for a fixed income investment with a higher rate of return than they might receive investing in treasuries, as an example.

Not all closing costs are the same

Depending on the thoroughness of the lender, you might receive closing costs aggregated together in one number for simplicity’s sake, but do recognize there is a laundry list of itemized costs that are wrapped in. If they haven’t broken these down for you, ask them to provide this detail, as this can be where the major differences between lenders lie.

This resource is helpful in providing a general range of what you can expect these line items to cost. When you compare one or many lenders with similar rates and closing costs, you’ll want to focus your attention on the ones that you can actually negotiate or shop around for, which includes the lender charges and third-party vendor fees (home appraisal, credit reporting, escrow services, etc.). 

Don’t be afraid to push back on any of these and share that another lender had lower closing costs, even if they didn’t have the better rate. You might be surprised after raising these points with the lender, suddenly there is more wiggle room as they fight for your business. Remember, you are in the driver’s seat in this competitive market.

The “adverse market fee” and how much it’ll cost you

Fannie and Freddie have incurred $6 billion in losses during the COVID-19 pandemic and, as government-sponsored enterprises, are required by Congress to stem those losses however they can, which includes levying new fees on those who are refinancing. The “adverse market fee” took effect on December 1, 2020 and is 0.50% on a refinanced loan. This can be substantial, but don’t be deterred. Make sure you know how much this is going to cost you in dollar terms and whether there is any promotion by the lender to help diffuse this cost. While this is not always possible and again depends on how badly the lender wants your business, there have been cases where lenders will provide an additional credit to offset some or all of this fee to close the deal.

What is your break-even point?

Now, let’s bring it all together and calculate the break-even point, which is the point in time where the interest and/or cash flow saved covers the initial costs of the refinance. There are several tools out there to help calculate this number and I have found NerdWallet’s Refinance Calculator and Bankrate’s Refinance Calculator to be the two most holistic and user-friendly.

When examining the results, notice how far out the break-even point is. Does this line up with your initial goals and priorities? How much interest are you saving by refinancing in total at different points along the timeline? Note that it’s rare for people to stay in their homes through the end of the term of their mortgage. According to the National Association of Realtors, Americans tend to stay in their home for 13 years on average. This can be a helpful reference point on the timeline for those who have no plans to move at all. 

When switching to a similar loan term (i.e. a 30-year to a 30-year), as a very rough guide, break even points in the first 0-36 months are considered good. If you can make back your closing costs within the first year, that’s exceptional and a strong data point in favor of moving forward with the refinance. On the other end of the spectrum, if you don’t break even until 3+ years down the line, that’s not necessarily a reason to immediately stop the exercise, but it is a reason to reconsider your initial goals. Were you looking to free up some cash flow each month? Are you taking cash out to fund another goal?

Armed with that important information, where ideally the new loan lowers your monthly payment, has a fairly short break-even point, and accomplishes your initial goals and priorities, be sure you lock the rate with the lender that has come out on top. This way, if there are any sudden moves with rates, you don’t need to start the process all over again, or wait until a better time comes around. 

After selecting the best rate, closing costs and lender for your specific situation, you should be on track to save thousands upon thousands of dollars in the future. And the exercise was still worthwhile even if it demonstrated that now isn’t the right time to refinance, you now have peace of mind that you aren’t leaving any money on the table during this historic period when it pays more to be a borrower than a saver. 

If you found this helpful, I’d encourage you to forward this on to a friend, family member or colleague to review before rates move higher.