The ads in the mortgage industry almost always focus on “we will give you the lowest rate.” The advice the government often gives is to shop for the lowest APR. While these approaches have merit, they typically overlook the issue of closing costs and how long it will take to recover the closing costs through interest savings. Some suggest refinancing when a borrower can lower the rate 2% or more. For reasons I explain below, we can easily justify refinancing for a much lower rate change.
The APR calculation is valid, but it is based on the assumption the borrower will remain in the home for the entire term of the loan and make the minimum payments for the term of the loan. The APR comparison process breaks down if the borrower sells the home before the loan has run full term, refinances before the loan has run full term, or prepays the loan.
Based on my personal experience and watching the behavior of many customers, I find the above assumptions rarely turn out to be true. My observation is that almost all loans are prepaid when the borrower moves; the borrower refinances before the end of the loan term, or prepays the loan. I do not have statistics to show the statistical repayment rate.
Making a Loan Choice
My preference is to look at the loan choice with three considerations:
- What happens if it is in place longer than I expect?
- What happens if the loan is in place for the time I expect it to be?
- What happens if the loan is paid off earlier than I expect?
The easiest of these is the comparison for a loan that lasts the expected time. People often choose hybrid ARMs because they expect to be in the house for 5-7 years and then move. If this really happens, then the choice works well. Unfortunately, many people chose ARM’s during the mid-2000s and then were trapped when the economy declined. Some found themselves in “exploding ARMs” with declining incomes. The result was an expensive foreclosure. We generally recommend choosing a loan that is tolerable if the borrower must stay in the property and not refinance for a much longer time than expected.
The other scenario we have seen play out over the last couple of decades is mortgages routinely being paid off early. While some are paid because of a sale, early payoff because of a refinance is more common. The refinances occur for either of two reasons: Market interest rates have declined or market home prices have increased. Either one can cause a refinance.
Lowest Rate vs. Lowest Fees
Every loan involves a choice between lowest rate, lowest fees, or some compromise of these. I generally recommend looking at the tradeoff between rate and fees through the lens of cost recovery time. If the tradeoff is such that a year or two of interest savings will recover the difference in fees, then choose the lower rate. If it will take 8-10 years of interest savings to recover the difference in fees, take the lower fees. The disclosure of trade off between rate and fees is not generally in a form for public distribution, but I am always happy to discuss it in person and explain the options to any borrower.
What is important is that we can often lower a borrower’s rate with no cost to the borrower, or provide a debt consolidation loan without increasing the interest rate. Let us do a free analysis of your situation to see how we can help you.